Cost-Benefit Analysis

Economics 3C03: Weekly Review 2

Cost-Benefit Analysis is a tool that helps governments evaluate projects to determine if they should be undertaken. We will review one method of cost-benefit analysis, its applications and limitations and how the government can address distributional concerns in their programs.

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One common method method for cost-benefit analysis is the net present-value criterion. The net present-value allows the government to determine if the benefits of a project outweigh the costs. In order to calculate the benefits and costs, the government must add up the benefits and costs for each year that the project will have an effect. One important consideration is that money received in the future is worth less than the same money now. To understand why this is the case, imagine that we have some amount of money, say $100. We could invest that money today and in three years our $100 might be worth $120. This means that money with a present-value of $100 would have a future-value of $120. Now, imagine that we know we will receive $120 in three years. We can work backwards to see that our $120 has a present-value of $100. This method of working backwards is how the government calculates benefits and costs in the future. The government finds the present-value of the benefits and the present-value of the costs. If the benefits are greater than the costs, then the project should be approved.

A common application of cost-benefit analysis is to compare different potential projects. If a local government can afford to build either a hockey rink or an indoor pool (but not both), the present-value criteria can help determine which one to build. The project with the highest net present-value can provide the greatest service to the community. One common issue with cost-benefit analysis is estimating financial values for non-monetary benefits. In our hockey rink and swimming pool example, it is extremely difficult to measure the benefits enjoyed by the townspeople. There is no consensus on how much enjoyment the hockey rink or swimming pool will provide nor is there even a consensus on how to quantify this enjoyment. In this case, the local government must estimate these benefits and apply a monetary value to them in order to conduct cost-benefit analysis. This arbitrary value judgement can significantly impact the results of the net present-value calculation. This provides a significant limitation to cost-benefit analysis and is one of the reasons that cost-benefit analysis is only one of the tools that policymakers use in their decision-making.

One concern with government projects is that the benefits are not always distributed evenly throughout society. In the case of our hockey rink or indoor pool, the neighborhood where the centre is built will receive more benefits than the other neighborhoods. It will be easier for the local residents to use the facilities and the facility may raise property values in the neighborhood. Some people may argue that it is unfair that some residents may benefit more than other residents in the same town. Public economists argue that as long as the benefits outweigh the costs, the initial distribution of benefits do not matter. If the net present-value is positive, some of the benefits can be redistributed to those that initially do not receive them. For example, a local government could use property tax on the local neighborhood to fund public transportation to the facilities so that everyone can enjoy the benefits of the project. In this case, the local neighborhood receives some benefits from the project and townspeople that live farther away can enjoy the benefits as well. Due to the fact that the net present-value was positive, the town is better-off with the facility than without it.

Cost-benefit analysis is a useful tool for informing government policy-making. With the use of an example, we explored the net present-value method, its limitations and distributional concerns for a new government project.

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