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Cost-benefit analysis


A technique which attempts to set out and evaluate the social cost and social benefits of investment projects, to help to decide whether or not the projects should be undertaken. The essential difference between cost-benefit analysis and ordinary investment appraisal methods used by firms is the stress on the social costs and benefits. The aim is to identify and measure the losses and gains in economic welfare which are incurred by society as a whole if the particular project in question is undertaken. In calculating the benefits of constructing a new underground railway, for example, as well as the revenues from ticket sales, we would take into account the value of reductions in travelling time to users, congestion costs to motorists, etc. Similarly in calculating the costs of a new airport: in addition to the cost of land acquisition, construction and subsequent operation, the losses in welfare resufting from aircraft noise · and spoliation of areas of scenic beauty would be included. As a result of this emphasis - taking into account all significant costs and benefits and not just the financial costs and revenues received and incurred by the agency undertaking the project - a major problem in cost-benefit analysis is the evaluation of certain types of cost and benefit.

The first problem is that of measurement in physical units. We may measure savings in travelling time in minutes and hours, and noise nuisance in decibels, but how do we measure the amount of pleasure derived from a particular piece of scenery? The second problem is that of reducing all costs and benefits to a 'common unit of account' so that they are comparable with one another. That is, to obtain an idea of the aggregate benefits and costs associated with a project, and to compare these for different projects whose costs and benefits are measured in different physical dimensions or none at all, it is helpful to reduce all magnitudes to some common 'unit of account'. Since the 'unit of account' most commonly used is money; this generally becomes the problem of evaluating costs and benefits in monetary terms. Questions which have to be answered are: what is the money value of time spent in travelling? What is the money value of the loss of visual amenity in the area in which an airport is located? In some cases, economists have developed ways in which such values may in principle be measured.

Ultimately, however, many of these problems of valuation can only be resolved by political decision, which hopefully reflects society's evalua tion of the costs and benefits which are not directly measurable in money terms (e.g. the value of unpolluted air or the value to be placed on reducing fatal accidents along a stretch ofhighway). This should not, however, be translated into the proposition that, since it is all a matter ofpolitics anyway, the cost-benefit analysis is irrelevant and unnecessary and itself a waste of resources.

Reference: The Penguin Dictionary of Economics, 3rd edt.