William K. Bellinger
How much to invest is a fundamental question applying equally well to socially valued public investments as to the private sector. Benefit-cost analysis is the cornerstone of the economic analysis of public policy, and is closely aligned with basic rational choice and market concepts from microeconomics. Information and other constraints often block the direct application of marginal analysis in policy decisions, but the conceptual role of marginalism can still be useful in interpreting cost-benefit analysis. While all policy analysis texts that emphasize the economic dimensions of policy cover the basics of marginal analysis, the sources of market inefficiency, and basic decision rules for policy analysis, the connections between marginal analysis and non-marginal policy decision rules are seldom emphasized. This chapter limits its discussion of marginal analysis to the concepts of optimal quantity and optimal allocation rather than the market based concepts of surplus, equilibrium and elasticity, which are discussed in later chapters. This chapter begins by reviewing marginal and non-marginal concepts and measures for policymaking, and then discusses a set of basic policy decisions that can be informed by these concepts. Student exercises are included and answered in the appendix to the chapter.
Arnold C. Harberger
This chapter presents a simple exposition of general equilibrium applied welfare economics. It focuses first on the efficiency costs of a set of tax distortions on different goods, and then explores the efficiency effects of adding a new tax to a set of already existing ones. It near considers non-tax distortions such as pollution and traffic congestion, followed by a discussion of distributional weights and basic needs externalities. Finally, it deals briefly with several strategic issues involved in implementing a national system for the benefit-cost analysis of public investments and other expenditures.
Charles Griffiths and Chris Dockins
Evaluating the benefits and costs of any action is fundamentally determined by the baseline, which determines the basis of comparison for the action. However, the topic of a baseline is often given limited attention in benefit-cost analysis (BCA) textbooks and journal articles, despite the fact that this is one of the first issues economists confront when doing applied analysis. This paper addresses the gap by discussing some of the nuances of defining and constructing a defensible baseline and illustrates these nuances with examples from the US Environmental Protection Agency (EPA). Core materials for BCA teachers include the narrative as well as links to documents, websites and regulatory impact analyses illustrating these baseline nuances.
Richard O. Zerbe
It is sometimes said that benefit-cost analysis adds up impacts “to whomsoever they accrue”. But in practice that general guidance is more complex and it is the issue of “standing” that defines more precisely whose benefits and costs are to be counted. As in law, where to bring a suit one must have “standing” before the court; so too in benefit-cost analysis must conditions be described for what and whose benefits and costs count. Key issues involve not only whose preferences count (should “foreigners”?), but also which preferences (should criminal activity count?) and over what period of time? As with law, some answers are not clear-cut but can create useful and informative class discussion on sensitive topics.
Per-Olov Johansson and Bengt Kriström
The typical approach in benefit-cost analysis is partial equilibrium. Thus, a policy’s impacts on other markets are ignored. We discuss partial equilibrium evaluation versus general equilibrium ones. It is shown that the rules coincide when markets are perfect and the considered policy is (infinitesimally) small. If changes in some parameters are discrete, the approaches produce different outcomes, in general. In particular, market-based (Marshallian) demand curves no longer reflects the willingness-to-pay for, say, a change in a price. Therefore, income-compensated (Hicksian) tools must be employed. Greater technical detail is expected here that may be more familiar to graduate students in economics.
Susan E. Dudley
In this chapter, students learn how benefit-cost analysis (BCA) is applied to US regulation. Students gain an overview of the federal regulatory process and the important role BCA plays in making regulatory policy. The chapter reviews how markets work in order to introduce the concept “market failure,” which agencies are required to identify to justify government regulation. Students should also gain an appreciation of possible government failures as well.
Gelsomina Catalano and Massimo Florio
In the contest of the European Regional Policy, benefit-cost analysis (BCA) is explicitly required, amongst other elements, as a basis for decision making on the co-financing of major projects by the European Structural and Investment Funds (ESIF). How to teach the principles and applications of BCA in an intensive short course (one week) targeted to an audience of civil servants and young professionals with a range of backgrounds (economics, public administration and others) from different countries? The content of this chapter is motivated by the experience gathered by the team of the University of Milan and Centre for Industrial Studies (CSIL) in seven editions of a summer school on BCA and other training courses. The objective is to distill some lessons learned from this experience.
Lisa A. Robinson
The value of small changes in mortality risks, conventionally expressed as the value per statistical life (VSL), is an important parameter in benefit-cost analysis. These risk reductions often dominate the benefit estimates for environmental, health and safety policies and regulations. As a result, their value has been extensively studied, raising questions about how to best synthesize the resulting research and to adjust it for different contexts. The VSL terminology has led to substantial confusion about what is being measured, however. The VSL reflects individuals’ willingness to pay for small reductions in their own mortality risks within a defined time period. It is not the value of preventing certain death.
This teaching note focuses on two common difficulties for students. The first is the failure to think in terms of marginal effects. Deciding whether something is worthwhile depends upon what other options are available. When confronted with a program that costs more than another but also has greater effects, students often don’t realize that they need to examine the marginal cost per marginal effect of the more expensive program relative to the other program. The second, related, difficulty is not realizing that, unless you have a value to place on the effects, you generally can’t say whether a project is worthwhile. Instead, students see that buying only one unit may provide a lower cost per unit than buying more units (assuming declining marginal effectiveness). Then they label that the most “cost-effective” option, and proceed to recommend that it be adopted. Several variations related to cost-effectiveness are discussed.