Paul R. Portney
The Concise Encyclopedia of Economics

Benefit-Cost Analysis

by Paul R. Portney
About the Author
Whenever people decide whether the advantages of a particular action are likely to outweigh its drawbacks, they engage in a form of benefit-cost analysis (BCA). In the public arena, formal BCA is a sometimes controversial technique for thoroughly and consistently evaluating the pros and cons associated with prospective policy changes. Specifically, it is an attempt to identify and express in dollar terms all of the effects of proposed government policies or projects. While never intended to be the only basis for decision making, BCA can be a valuable aid to policymakers.

Although conceived over 150 years ago by the French engineer Jules Dupuit, BCA saw its first widespread use in the evaluation of federal water projects in the United States in the late 1930s. Since then, it has also been used to analyze policies affecting transportation, public health, criminal justice, defense, education, and the environment. Because BCA has had some of its most important and controversial applications in environmental policy, this discussion of key issues in BCA is illustrated with examples from the environmental arena.

To ascertain the net effect of a proposed policy change on social well-being, we must first have a way of measuring the gains to the gainers and the losses to the losers. Implicit in this statement is a central tenet of BCA: the effects of a policy change on society are no more or no less than the aggregate of the effects on the individuals who comprise society. Thus, if no individual would be made better off by a policy change, there are no benefits associated with it; nor are there costs if no one is made worse off. In other words, BCA counts no values other than those held by the individual members of society.

It is equally important to note that benefits and costs, even though they are almost always expressed in dollar terms in BCA, go well beyond changes in individuals' incomes. If someone's well-being is improved because of cleaner air—through improved visibility, for instance—he experiences a benefit even though his income may not change. Similarly, an increase in pollution that puts people at higher risk of disease imposes a cost on them even though their incomes may not fall. Indeed, a person would bear a cost (be made worse off) if the pollution posed a threat to an exotic and little-known species of animal that he cared about. Some criticize BCA on the grounds that it supposedly enshrines the free market and discourages government intervention. However, BCA exists precisely because economists recognize that free markets sometimes allocate resources inefficiently, causing problems such as dirty air and water.

How, then, are benefits and costs estimated? While it is generally assumed that they are measured differently, benefits and costs are actually flip sides of the same coin. Benefits are measured by the willingness of individuals to pay for the outputs of the policy or project in question. The proper calculation of costs is the amount of compensation required to exactly offset negative consequences. Willingness to pay or compensation required should each be the dollar amount that would leave every individual just as well off following the implementation of the policy as before it.

Suppose, for example, we wished to evaluate the benefits and costs of a proposal to control air pollution emissions from a large factory. On the positive side, pollution abatement will mean reduced damage to exposed materials, diminished health risks to people living nearby, improved visibility, and even new jobs for those who manufacture pollution control equipment. On the negative side, the required investments in pollution control may cause the firm to raise the price of its products, close down several marginal operations at its plant and lay off workers, and put off other planned investments designed to modernize its production facilities.

How do we determine the willingness to pay for the favorable effects? First, it is relatively easy to value the reduced damage to materials. If, say, awnings will now last ten years rather than five years, it is straightforward to multiply the number of awnings times their price to get an idea of savings to consumers—so long as the price of awnings is not affected by the policy. If reduced pollution meant more agricultural output, it would be similarly easy to value because crops have well-defined market prices. In other words, when benefits involve marketed outputs, valuing them is not terribly difficult.

But what about reduced health risks or improved visibility? Because these are not things that people buy and sell directly, it is much less clear how to estimate the willingness to pay (the value of the benefits). Two major techniques are available. One, called the contingent valuation method, involves asking people directly, via sophisticated questionnaires, how much they would pay for reduced health risks or improved visibility. This approach makes it possible to estimate the benefits of programs—for example, the preservation of a remote wilderness area—for which other techniques generally are inapplicable. However, this approach has its limitations. One is that it often requires individuals to place dollar values on things they are unused to viewing in economic terms. As a result, their responses may not be as reliable as we would like. Also, responses to surveys are hypothetical; economists prefer values revealed in actual market transactions.

Another approach is to observe how much people are willing to pay for goods that have an environmental quality component. For example, houses in unpolluted neighborhoods sell for more than those in polluted areas. Using statistical techniques to hold constant the other characteristics of houses and the neighborhoods in which they are located, it is possible to identify a "clean air premium." This provides important information on the value to individuals of air quality improvements. A similar approach for estimating how much people value pollution control and other public policies that reduce health risks is to estimate how much of a wage premium they are paid to work in jobs that pose health risks. Still other techniques infer values from such things as the time and money people spend traveling to and from desirable recreation sites.

It is generally assumed that cost estimation involves a mere toting up of the expenditures that affected parties must make, as in our example of the firm controlling air pollution. As suggested above, however, matters are more complicated than this. Some firms not initially affected by regulation will incur higher costs—those purchasing the product of the regulated firm, for example. These "ripple" effects must be taken into account. Or if the polluting firm closes down some operations rather than purchasing pollution control devices, its expenditures will be zero, but the social costs are still positive. In such cases the costs are borne by employees, shareholders, and purchasers of its output. Unfortunately, techniques for making these more sophisticated cost estimates are still in their infancy; for this reason, virtually all BCAs still use direct expenditures as rough measures of true social costs.

Three additional issues in BCA bear mention. First, government policies or projects typically produce streams of benefits and costs over time rather than in one-shot increments. Commonly, in fact, a substantial portion of the costs are incurred early in the life of a project, while benefits may extend for many years (perhaps beginning only after some delay). Yet, because people prefer a dollar today to one ten years from now (see interest), BCA typically discounts future benefits and costs back to present values. Not only are there technical disagreements among economists about the interest rate (or rates) at which these future impacts should be discounted, but discounting raises ethical problems as well. At a discount rate of 10 percent, for instance, $1 million in benefits to people fifty years from now has a present value of only $8,500. This powerful effect of discounting is of concern when BCA is applied to the evaluation of policies with significant intergenerational effects, such as those pertaining to the prevention of global climate change or the disposal of high-level radioactive wastes (which will be lethal for hundreds of thousands of years).

A second sticking point in BCA is the fact that the willingness to pay for the favorable effects of a project or policy depends on the distribution of income: a billionaire would be able—and therefore willing—to pay more than a pauper for the same improvement in environmental quality, even though both cared about it with equal intensity. Some critics dislike BCA because it reduces benefits to pure dollar amounts. But BCA analysts use dollars to estimate benefits because there simply is no other way to directly measure the intensity with which people desire something.

Third, suppose that the aforementioned problems were to disappear, and that benefits and costs could be easily expressed in dollar terms and converted to present values. According to modern BCA, a project or policy would be attractive if the benefits it would produce exceed the costs. This is because, in theory, those gaining from the project could compensate those made worse off and still be better off themselves. In our factory example, for instance, those enjoying the benefits of cleaner air gain more than the losses to consumers who must pay more for the factory's output or to workers whose jobs are eliminated. Thus, the winners could compensate the losers and still come out ahead. In practice, of course, this compensation is seldom paid. Therefore, even the most efficient projects create some losers. This can undermine support for BCA in general and often makes it politically difficult to enact efficient policies, or, conversely, to block very inefficient projects, whose costs exceed benefits.

In spite of these sticking points, BCA seems to be playing a more important role in government decision making. One reason may be that shunning a comprehensive, analytical approach to decision making simply because it has flaws inevitably pushes decisions back into the realm of the ad hoc and purely political. While BCA does have very real shortcomings, it appears preferable to smoke-filled rooms.

About the Author

Paul R. Portney is president and senior fellow at Resources for the Future, an environmental think tank in Washington, D.C. He was previously a senior staff economist with President Carter's Council on Environmental Quality.

Further Reading

Gramlich, Edward M. Benefit-Cost Analysis of Government Programs. 1981.

Hammond, P. Brett, and Rob Coppock, eds. Valuing Health Risks, Costs, and Benefits for Environmental Decision Making. 1990.

Kneese, Allen V. Measuring the Benefits of Clean Air and Water. 1984.

Kopp, Raymond, and Michael Hazilla. "Social Cost of Environmental Quality Regulations." Journal of Political Economy 98 (1990): 853-73.

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