Cost benefit analysis

Cost benefit analysis (CBA) is based on welfare and utility theories. Early attempts to construct a theory of utility date back to the end of the eighteenth century. Jeremy Bentham was among the first scholars to define the principles of utility by suggesting a measurement of quantities of pleasure and pain through four dimensions: 1) intensity, 2) duration, 3) certainty, and 4) propinquity (Stigler 1950 p. 308). Furthermore, Bentham introduced the measurement of pleasure through money and established a set of propositions on the utility of income. According to the economist David Ricardo, a contemporary of Bentham, wealth is indicated by ‘the necessaries, conveniences, and amusements’ one can afford. However, their value is not measured in monetary terms but in terms of the amount of labour necessary to produce a commodity (Stigler 1950).

The notion of welfare is closely related to that of utility. Based on the definitions of several authors, Fischer (2004) describes welfare as a concept associated with the ideas of utility, happiness, and benefit, or wellbeing. A benefit can be defined as ‘any gain in human wellbeing (‘welfare’ or ‘utility’) and cost is defined as any loss in wellbeing’

(Pearce 1998 p. 86). Moreover, welfare economics is concerned with the identification of actions that increase social utility. This is similar to utilitarian theory, which determines the welfare of human beings according to the completion of their concerns (Marggraf & Streb 1997). The economist Arthur C. Pigou (1924 p. 10) puts forward two propositions of welfare: The first defines the elements of welfare as ‘states of consciousness’, and the second assumes that welfare belongs to ‘the category of

greater and less’. The question is how changes in the welfare of an individual or of groups can be measured. According to Pigou (ibid., p. 11), money is the measurement instrument in social life. Hence, only those elements of changes in social welfare can be measured that are directly or indirectly related to the benchmark of money. These areas of social welfare are called economic welfare. The aim of increasing social or economic welfare is related to the concept of economic efficiency, the Pareto efficiency (Fischer 2004 p. 20), which describes a social state in which the betterment of one person is only possible if at least one other person suffers a disadvantage (Schäfer & Ott 1986 p. 24).

This principle did not prove to be useful for political decision making because it does not include the comparison of utility between individuals (Fischer 2004). Based on the Pareto efficiency, Kaldor and Hicks developed an extended decision rule for the choice between two social states. The Kaldor-Hicks criterion states that a decision that favours one member of a society and discriminates against another should only be made if it is possible to redistribute parts of the gain made by the favoured individual to the other person. The gainer still should have an advantage after compensation of the loser (Schäfer & Ott 1986 p. 30). If the consequences of an economic transaction imply that gainers are better off after compensation of the losers, then this state can be considered as Pareto-superior and the decision should be made accordingly. Briefly, if benefits related to an economic transaction are larger than costs, the action can be seen as efficient (Fischer 2004). The Kaldor-Hicks criterion should be taken as a hypothetical test for the outcomes of political decisions because it does not require the real compensation of the losers. The execution of these hypothetical tests helps the decision-maker to quantify the positive and negative effects of a project and compare these quantities by means of a single metric. This procedure simplifies the evaluation of projects to a great extent compared to the rather intuitive evaluation procedures used previously. Thus, compensation tests could be seen as the basis of modern CBA. It is important to note that Kaldor-Hicks and CBA vary in terms of their metric: the former does not use money as a yardstick, while the latter does (Adler & Posner 1999).

Despite its convincing central idea, the Kaldor-Hicks rule has some major shortcomings. The first is that it leaves out distributive justice because it treats one unit of money as having the same value to everyone. This does not comply with reality, where the marginal utility of income is different to different individuals (Posner 2001).

Secondly, the rule is not practicable because compensating the losers is, in some cases, hardly feasible due to high administrative costs. It is, therefore, more a conceptual ideal than a practical instruction for compensating individuals for their losses (Fischer 2004).

The CBA approach was probably first applied by the French engineer and economist Jules Dupuit (1844), who postulated the principle that investment decisions should meet a criterion that benefits exceed costs (Pearce 1998 p. 85). Still today, the basic rationale of CBA is that ‘things are worth doing it if the benefits resulting from doing them outweigh their costs’ (Sen 2001 p. 98). Furthermore, Dupuit founded the marginal utility theory, distinguished total and marginal utility, and discovered the

‘consumers’ surplus’ (Stigler 1950). Consumers’ surplus is an important basic notion, in this context representing one of the two components of consumers’ willingness to pay (WTP) for a good or a service. In a marketplace situation, one component is the price of the good and the other is the excess WTP over the price, which is the consumers’ surplus. Thus, WTP measures the net gain or utility from the purchase of a marketed good (Pearce & Özdemiroglu 2002). For choosing between different alternatives of a marketed good, individuals use certain criteria that are linked to their personal preferences. Pearce & Özdemiroglu (2002 p. 18) state in this regard that ‘any appraisal requires criteria for choosing between alternatives. Different criteria may entail trade-offs, such as between cost and quality or performance […]’.

Next, money is introduced as a weight that can be used to measure willingness to pay and willingness to accept:

Cost benefit analysis uses money values as weights, because they express people’s willingness to pay (WTP) or willingness to accept compensation (WTA). This produces the important characteristic that benefits and costs can be directly compared, and specific actions can be compared with doing nothing (i.e. the base case scenario).

(Pearce & Özdemiroglu ibid. p. 18)

Willingness to pay measures how much an individual is willing to pay to secure a gain in wellbeing (the benefit) or how much an individual is willing to accept in compensation if he or she loses a gain. Thus WTP and WTA are measures of human preferences (Pearce 1998). However, not only costs and benefits form the basis of decisions as CBA also takes into account the net benefits after deducting costs from benefits (Sen 2001).

To measure the preferences of individuals, a monetary value is attached to non-marketed goods, for example, the environment. The United States and the United

Kingdom in particular employ CBA to investigate people’s preferences for different monetary levels in situations such as the introduction of a new tax for the preservation of an environmental good. Despite the popularity of CBA within regulatory agencies in both countries, there is opposition to the use of the method. Pearce (1998 pp. 96) discusses three main objections to CBA.

The first criticism implies that CBA is based on neoclassical economies, which presume that individuals are motivated by self-interest and that social decisions should reflect what individuals want. However, today it is believed that social decisions should be based on the common public good, and indeed, individuals have various motives for their preferences — including the feelings of ‘warm glow’ or ‘moral satisfaction’. The second objection derives from the argument that nature has

‘intrinsic’ value independent of individual’s preferences. Nonetheless, in some studies, respondents indicated having intrinsic value as their motivation but were at the same time unwilling to pay anything for nature conservation. In one study, almost all respondents said that, if nature conservation costs nothing, wildlife and wilderness areas have a right to exist. As soon as costs were introduced for nature conservation, the percentage of respondents in favour of preserving wildlife and wilderness areas dropped by approximately 50 percent. Thus, it was suggested, individuals made a trade-off in their preferences, but at a high price to the environment. The third criticism is that the use of money as a metric debases the environment in that it is treated as a supermarket good.

On the other hand, environmental conservation does have its costs, and, furthermore, monetary valuation of nature conservation does not debase nature but can help to preserve it. Nussbaum (2001 p. 195) says in this regard that assigning ‘a monetary value to an option does not, however, imply that we have reduced the good so valued to nothing but the common coin of cash’. However, CBA has its limits with regard to policy decisions concerning social or moral issues. There are, for instance, several religious and ethnic groups who wish to keep their children out of school, such as the Amish people in the United States and the Roma in Romania⁸. If we were to

8 The US government does allow children to be educated at home rather than at school—as long as certain educational standards are met (von Schoff, 2009 personal communication). The Roma (gypsies) in Romania do not want any school or education for their children at all. Nussbaum (2001 p. 190) says in this regard: ‘We can give people an acceptable level of liberty of conscience while insisting on compulsory primary education.’

conduct a CBA, the stated preference of parents belonging to these groups would be

‘no school for our children’. Should the government follow their stated preference and allow these parents to keep their children out of school? The answer must be ‘no’ (for a discussion of moral implications see Nussbaum 2001). An overview on the most important critiques of the method is given by Frank (2001). Apart from the pros and cons regarding CBA, it is a one of several useful tools for assessing people’s preferences, which form the basis for decisions governments and other administrations have to make. If CBA is ‘taken as [a] pragmatic instrument, agnostic in the deep issues and designed to assist people in making complex judgements where multiple goods are involved’ (Sunstein 2001 in Adler & Posner 2001 p. 321), then its practical value is great because people have cognitive limitations and therefore may have difficulty thinking clearly. Cost-benefit analysis can overcome these limitations as it is a rational discipline that helps in decision making (Adler & Posner 2001). In this pragmatic sense, CBA is used in the frame of the present study.