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BX3033:03 Cost Benefit Analysis James Cook University

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Cook University

BX3033:03 Cost Benefit Analysis James Cook University

BX3033 – COST BENEFIT ANALYSIS NOTES
Topic 1 (a) – Introduction to CBA
– CBA in its modern form, it is considered to have started in 1936 with the US Flood Control Act,
which said that flood control was desirable if:
“The benefits to whomsoever they may accrue are in excess of the estimated costs”
What is CBA?
– Cost – benefit analysis is a procedure for comparing alternative courses of action by reference to
the net social benefits that they produce for the community as a whole
– The term ‘net social benefit’ refers to the difference between social benefits and social costs.
– Benefits and costs are ‘social’ in that they are measured for society overall; they are not limited
to those received who are directly involved in the project or to market transactions.
– Thus, they tend to be identified on a more comprehensive basis than private sector evaluations.
– The comparison between costs and benefits is achieved through valuing both costs and benefits in
money terms.
– Some costs and benefits do not have dollar values. These costs and benefits are known as
‘intangibles’. They require special treatment in order to gain dollar values.
– Since costs and benefits occur at different points in time they are discounted as part of the
comparison.
– CBA is not based on popularity of a project
Overcompensation Test
Notice:
– CBA may recommend a project in which most people would be worse off.
– In order for the project to be considered efficient, the net gainers would have to be greater than
the net loss to the losers
– That is, the grainers must be able to overcompensate the losers, if necessary
– This is called the “Kaldor – Hicks compensation test”
Comparison between CBA and Firm’s NPV
CBA is similar in process to NPV undertaken for firms, however there are important
differences:
– CBA is concerned with the welfare of society, whereas NPV (firm) is concerned with the welfare of
the firm alone
– CBA includes both private and external benefits and costs whereas NPV (firm) does not includes
externalities
– NPV (firm) includes tax, whereas CBA does not
– The discount rate used in CBA reflects the cost of capital to society overall, whereas NPV (firm)
uses a discount rate that reflects the cost of capital to the firm alone
– CBA is also concerned with the consequences of a project on the distribution of income and
wealth, whereas NPV (firm) is not.
Uses of CBA
Cost benefit analysis has been widely used in the following contexts:
– Accepting or rejecting a single project – Example: should a pipe be built to take water from
the Burdekin dam to SE Queensland
– Choosing the appropriate scale of a project and/or timing for a project – Example: should
a dam wall be 30 metres high or 60 meters high?
– Choosing a number of mutually exclusive projects – Example: should extra resources be
used for treatment of disease or disease prevention?
– Deciding the optimal set or combination of discrete projects from a larger number of
discrete alternative projects – Example: Should a development combine housing, shopping,
parks and office space, or only housing?
– Evaluating government approvals for projects and for policies – Example: Kakadu
Conservation Zone Development, Ord River development, Darwin-Alice Springs Railway
CBA is Part of Welfare Economics
– Welfare Economics or Normative Economics is that part of economics that is concerned with
value judgements (VJs) – CBA is base on value judgements about what is “efficiency” and how it
should be measured.
– A VJ is concerned with what ought to be:
Example: “A is good-better-worse than B“
– VJs cannot be verified by appealing to facts.
– “Judgments of fact” (JF) can be.
Example: “A is larger than B”. Both A and B can be measured, at least in principle, and a decision
can be made
CBA fundamental Value Judgements
• Economics can be divided into positive economics – concerned with what is was or will be, and
normative economics – concerned with what ought to be.
• CBA is a part of normative economics. Its fundamental value judgments are:
(a) Individuals’ preferences should count in measuring benefits and costs; and
(b) Individuals’ preferences should be “weighted” by their “willingness to pay” (which is
correlated to income).
Criticisms of CBA
– False accuracy in valuation of Benefits and Costs
– Valuing life, morbidity, etc.
– Self – serving analysis
– Political manipulation
– Political science attack
– Radical critique
A CBA usually involves these following steps:
1. Carefully identifying the decision problem?
Ex: should the dam (in a given place, constructed in a particular way etc) be built?
2. Identify the constraints to a successful completion of the project?
Constraints on meeting the objectives should be studied to ensure the project is feasible. Constraints may
include:
– Financial resources – will there be enough money to build the dam etc?
– Distributional (for example, requirements relating to the distribution of project benefits among
individuals or groups)
– Managerial (for example, limits on the quantity and/or quality of staff available to implement
the project – build the dam);
– Environmental (for example, environmental protection standards which must be met – will the
required environmental flow prevent the dam from being successful).
3. Identify the alternatives to the project being considered?
4. Identify the benefits?
These are likely to include:
– The value of output – sometimes as reflected in revenues generated by a particular project,
sometimes by consumer surplus from the extra output;
– The scrap value of the project’s capital equipment;
– Avoided costs – costs which would have been incurred in the ‘do nothing’ or ‘without project’
situation;
– Productivity savings – reductions in existing levels of expenditure which can be shown to result
from the project or programme;
– External benefits possibly in the forms of improved health and environmental – these typically
raise problems of valuation; and
– Reduction in unemployment (for the nation) where it can be shown to be a result of the
project.
5. Identify the costs
Costs will include such items as:
– Capital expenditures;
– Operating and maintenance costs for the expected economic life of the project;
– Labour costs;
– Costs of other inputs (materials, manufactured goods, transport and storage, etc);
– Research, design and development costs;
– Opportunity costs associated with using land and/or other resources; and
– External costs such as environmental air pollution, noise, loss of biodiversity, loss of wilderness.

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BX3033:03 Cost Benefit Analysis James Cook University

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