ST BENEFIT ANALY

COST BENEFIT ANALYSIS

MMS 503

George Mandewo
  COST means how much you have to give up of
DEFINITION other things or resources to carry out and
implement the project
OF KEY  BENEFIT means how much the individual is willing
TERMS to “give up”, i.e. to pay for the benefit (welfare
increase) from the project
  Cost –Benefit analysis is a technique that can be
used to evaluate government projects. (Edgar K.
Browning Inc.)
DEFINITION
 Cost-Benefit Analysis: a systematic attempt to
… Cont’d measure and weight together all costs and benefits
from a project, with respect to whether the project
is profitable or not, in the economic sense.
  Public Sector is composed of state or state-related
DEFINITION organizations which provide goods and services to
the public without a profit motive.
… Cont’d
Common
terms  Private cost / Internal cost
used in These are costs incurred by those who buy products
and by those who produce products e.g. cost of a
Cost- beer bottle or cost incurred in producing a shirt.

Benefit
Analysis.
  Private Benefits / Internal Benefits
Common  These are benefits received by those who buy
products and those who produce products
terms…  E.g. private benefit from buying a bottle of beer is
Cont’d the enjoyment received from drinking it and the
private benefit of a shirt is the revenue it receives.
  Externalities / Spill-Over Effect
 Private cost and benefit go through market
Common mechanism and have a price attached to them.
 However, externalities do not go through the price
terms… mechanism and so do not a price attached to them.
Cont’d  It is a cost to a third part i.e those not directly
involved in production or consumption of the
product.
  Negative Externalities / External Cost
 These are costs imposed on third parties of
economic activity of others. E.g. if Jim buys and
Common drinks beer this may have an adverse effect on
others like becoming a nuisance at a public place or
terms… make mistake at work.
 In the production of a shirt negative externalities
Cont’d includes environmental pollution and visual
pollution.
  Positive Externalities / External Benefits
 These are benefits to third parties from the
Common consumption and production by others. e.g.
drinking beer may make Prof. Ayele more sociable
terms… to friends from his more cheerful behaviour.
Cont’d  The production of a shirt can result in creation of
employment which results in people spending more
on consumables hence other shops benefit.
  Social Cost
 It is total cost to society of an economic activity. It is
Common the full opportunity cost i.e what individual
consumers and producers forgo (In terms of price
terms… paid or expenditure on factors of production) plus
Cont’d what third parties forgo (e.g clean air and safety)
 Social cost = Private costs + Negative
Externalities
  Social Benefits
 This is total benefits to society from an economic
Common activity.
terms…  Social benefit = Private benefits + Positive
externalities
Cont’d  NB: Social benefit will equal private only if
there are no positive externalities.
The Aim of Cost Benefit Analysis

 The aim is to gauge the efficiency of the

intervention relative to the status quo. The costs
and benefits of the impacts of an intervention are
evaluated in terms of the public's willingness to pay
for them (benefits) or willingness to avoid paying
for them (costs).
  To evaluate government projects.
Why Cost  To focus on how the government decides on
whether or not to pursue a particular project?
Benefit
 To provides a way of organizing information about
Analysis? a program under consideration so that priorities
may be reasonably established.
  To estimate whether the gain to society
(benefit) from the project is greater than
the social sacrifice (cost) required to
undertake the project.
Why Cost  If costs are less than benefits, the
Benefit…? project is worthwhile, if not, then the
Cont’d project is not worthwhile.
 Worthwhile projects improve the total
economic affluence of society because
they direct resources where their use
provides a greater return than would
other alternative use.
  Because economic resources in a society are
limited
Why Cost  Give priority to the most profitable
projects/actions.
Benefit…?  Decide ranking order (most profitable project
Cont’d implemented first).
 Use scarce resources where the value added (i.e.
growth in “GNP”) is largest.
  Guide the decision-making process
Why Cost  Inform the authorities of costs and benefits of the
project
Benefit…?  Transport infrastructure and operations
Cont’d  Environment, health care
 Regulatory reforms
  To support decisions on provision of public goods as
a public responsibility. Why is provision of public
Why Cost goods a public responsibility?
 It is difficult and/or costly to exclude people from
Benefit…? access to public goods (police, defence, roads with
Cont’d excess capacity).
 One person’s use of the public good does not
exclude others from using it.
  Problems with private provision of public goods:
Why Cost  If people cannot be excluded from use, then they do
Benefit…? not have any “property rights”, and thereby having a
weak incentive for supplying such goods. The
Cont’d “others” are seen to benefit from one’s own
contribution without contributing themselves.
  Everyone wishes to use the public goods as much as
desired, while “everybody else” gets the bill (“free
rider”).
Why Cost  Weak incentives (and possibilities) for revealing
Benefit…? true information about user benefits from using a
price system.
Cont’d
  Static Cos-Benefit Analysis
CB=Bo - Co= B/C>1
Measuring If it is B/C>1 There will be positive decision
Cost-Benefit to implement the project
If B/C<1 There will be negative decision
  Dynamic Cost-Benefit Analysis
 PVCB= Bo-Co + B1-C1 + B2-C2 +…. + Bn -Cn
Measuring
 (1+r)o (1+r)1 (1+r)2 (1+r)n
Cost-Benefit
Cont’
  Risk (Expectations) Analysis
Measuring EPVNB= Risk Premium
Cost-Benefit  Bo-Co + B1-C1 + B2-C2 + …. +Bn -Cn
Cont  (1+r + δ)o (1+r + δ)1 (1+r+ δ)2 (1+r+ δ)n
Difficulties in Measuring Cost
1. A Analysis
Benefit challenging task is to reveal and
calculate the benefits from public
goods, and compare them with the
costs.
2. The requirement to express CBA in
quantitative terms e.g. When you
construct a dam to control flood
damage how can benefits be
measured in monetary terms. The
free rider problem means that we are
not able to estimate potential
beneficiaries accurately since theory
says dollar benefit should equal
maximum amount that people would
be willing to pay for the service.
 3. Rough estimates can however be done for the
benefits of the dam in terms of preventing crop
damage from floods i.e. estimate average
Difficulties… annual volume of crops destroyed and multiply
.. Cont’d by the market value. This figure is however
never accurate.
 4. The CBA requires a comprehensive picture
covering the following: Political, economic,
Difficulties… psychological, social, anthropological etc
which are difficult to quantify e.g. the land
.. Cont’d reform programme in Zimbabwe.
 5. In most cases an output of government
Difficulties… expenditure is not sold and so it does not have
.. Cont’d a market value. E.g. Security and policing
services
 6. Problem of direct and indirect
benefits e.g. taking the example of
dam project, direct benefit relate to
flood control and recreational
services like fishing, boating and
camping are indirect costs. All the
Difficulties… effects of a project that are
.. Cont’d considered desirable by those who
are affected are benefits and should
be counted as such. Some benefits
are very difficult to estimate e.g. how
much is it worth for home owners in
terms of view with homes
overlooking the dam.
 7. Some benefits may be too small or too costly
to measure.
8. Error of Counting - pecuniary externalities as
benefits. Any government project is likely to
Difficulties… affect the prices and quantities of other goods
.. Cont’d purchased e.g. recreation at a new dam can
result in increase in boats and fishing material.
Higher prices are costs to buyers and benefits to
sellers. It is best to disregard these since they
have a zero net effect.
Difficulties…
9. Double count of benefits e.g. an estimate of how much a view of the
.. Cont’d lake is worth to near by home owner and the real value of the house.
To include both values is to double count since the increase in property
value is influenced by the good view.
 10. When externalities or public goods are
involved. There is no accurate way to
determine benefits of defence, education,
Difficulties… health insurance and welfare programs. These
provide intangible benefits which are difficult
.. Cont’d to express in monetary terms e.g. prevention
of death as result of health insurance.
 11. Issue of intermediate and final benefits e.g.
Difficulties… Weather forecast provides a final benefit to
Masanga who is planning for a holiday and an
.. Cont’d intermediate benefit to Moyo an air traffic
controller.
 12. Inside and outside benefits. Flood control
measures in Kariba can ultimately affect or
Difficulties… benefit people in Mozambique, how do you
.. Cont’d measure the cost and benefit?
 13. Tangible and intangible benefits. Tangible
benefits and costs are those with market value.
On the other hand intangible benefits and costs
Difficulties… are social goods and social costs e.g.
beautification of an area resulting from an
.. Cont’d irrigation project. Intangible may also include
health or loss of life which are private in nature
but cannot be readily assessed in money terms.
All the same these form part of the analysis
 14. Biases
 Strategic bias- answers are given to influence the
outcome especially if one is to benefit.
 Information bias-these are values attributes caused
Difficulties… when one assess the situation with out
 Strategic point bias- answers are given like in
.. Cont’d multiple choice scenario and the respondent is
restricted to the given choices.
 Hypothetical bias- supposing or imaging a future
situations.
  Political interference
 Some projects are implemented irrespective of
Difficulties… negative results of CBA because of political
influence.
.. Cont’d  Political influence or government policy of balanced
development may sideline the use of CBA.
  Cost Effective Analysis
 Is an analytical technique to chose the
most efficient method for achieving a
project.
 Cost of alternative are in monetary
terms
Alternativ  Effectiveness is defined by the degree
of goal attainment
es to Cost
NB- This method is different form cost
–Benefit benefit analysis because of its limited
Analysis view of cost and effectiveness.
Cost benefit analysis is better tool
because it encompasses society wide
impacts of alternatives.
 Although there are a number of negative
associated with implementing cost benefit analysis
in government project the tool should not be
discarded as it can be successfully used for purely
economic project and other social project. It gives a
good indication of cost and benefit involved in
project implementation. It is also an important tool
to budgeting.
 Government performance especially to the
electorate can be measured using CBA.
  Challenges presented above are real life issues in
cost benefit analysis and there is no immediate
solution in dealing with them since theory requires
CONCLUSIO that cost and benefit should be illustrated in
N quantitative terms. This explains why cost benefit
analysis has been limited to areas in which benefits
are relatively easy to measure e.g. irrigation, flood
control and transportation project.
  Browning, K. Edgar & Jacquelene (1987),
Public Finance and the price System, third
edition, Macmillan publishing Company
New York.
 Grant, S.J, Stanlake’s Introductory
Economics, 7th Edition. Longman 2003.
 Musgrave, A. Richard & Musgrave (1989
REFERENCE ), Public Finance in Theory and Practice,
S 5th edition, Mcgraw-Hill International
Editions
 Nobbs, J. and Hopkins, I. Economics, A
Core Text 4th Edition, McGrow-Hill 2004.
 http://en.wikipedia.org/wiki/CostBenefit
Analysis