1.2. Cost benefit analysis

Question 1

CBA

Answer 1

Cost Benefit Analysis

Question 2

CBA definition

Answer 2

An investment appraisal technique that takes into account all the social costs and social benefits of an economic decision.

Question 3

Social costs consist of

Answer 3

Private costs and External costs

Question 4

Social benefits consist of

Answer 4

Private benefits and External benefits

Question 5

Uses of CBA

Answer 5

Large scale public sector investment projects:

• Transportation
• Health / education
• Energy

Question 6

Difference between CBA and private investment

Answer 6

• CBA is used by the government
• private investment used by the private sector
• CBA considers social costs and social benefits
• private investment only considers private costs and private benefits

Question 7

Aims of CBA

Answer 7

• Include externalities (external costs and benefits) in an investment project.
• Estimate future costs and benefits from an investment decision.
• Appraise (evaluate) an investment project.

Question 8

Stage 1 CBA

Answer 8

Identify all relevant costs and benefits.

However:

• Difficult to identify external costs and benefits.
• Spillover effects can be more wide-ranging than expected.

Question 9

Stage 2 CBA

Answer 9

Assign monetary values to all costs and benefits.

However:

• Only easy where market prices exist.
• Difficult to calculate where market prices do not exist.
• May need to use “shadow prices”.

Question 10

Stage 3 CBA

Answer 10

Forecasting future costs and benefits.

However:

• Difficult to estimate future costs and benefits.
• Costs usually occur today but benefits might be further in the future.

Question 11

Stage 4 CBA

Answer 11

Compare the data and make a decision.

✓ if Social benefits > social costs
X if Social costs > social benefits

Question 12

Evaluating CBA

Answer 12

1) Provides a coherent framework for making decisions when market mechanism does not fully work.
2) Many difficulties associated with CBA:
- Some costs and benefits do not have market prices (have to be estimated using “shadow prices”).
- Which costs and benefits should be included?
- Valuation of external costs and benefits is difficult / impossible.
- May not cover everyone affected.
- Distributional consequences (over time, location, social status).
- Impact of pressure groups.
- Acceptance by the community.