Cost-Benefit Analysis: From Wikipedia, The Free Encyclopedia
Cost-Benefit Analysis: From Wikipedia, The Free Encyclopedia
Cost-Benefit Analysis: From Wikipedia, The Free Encyclopedia
Contents
[hide]
• 1 Theory
• 2 Application and history
• 3 Accuracy problems
• 4 See also
• 5 References
• 6 Further reading
• 7 External links
[edit] Theory
Cost–benefit analysis is typically used by governments to evaluate the desirability of a
given intervention. It is heavily used in today's government. It is an analysis of the
cost effectiveness of different alternatives in order to see whether the benefits
outweigh the costs. 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 pay to
avoid them (costs). Inputs are typically measured in terms of opportunity costs - the
value in their best alternative use. The guiding principle is to list all parties affected
by an intervention and place a monetary value of the effect it has on their welfare as it
would be valued by them.
The process involves monetary value of initial and ongoing expenses vs. expected
return. Constructing plausible measures of the costs and benefits of specific actions is
often very difficult. In practice, analysts try to estimate costs and benefits either by
using survey methods or by drawing inferences from market behavior. For example, a
product manager may compare manufacturing and marketing expenses with projected
sales for a proposed product and decide to produce it only if he expects the revenues
to eventually recoup the costs. Cost–benefit analysis attempts to put all relevant costs
and benefits on a common temporal footing. A discount rate is chosen, which is then
used to compute all relevant future costs and benefits in present-value terms. Most
commonly, the discount rate used for present-value calculations is an interest rate
taken from financial markets (R.H. Frank 2000). This can be very controversial; for
example, a high discount rate implies a very low value on the welfare of future
generations, which may have a huge impact on the desirability of interventions to help
the environment. Empirical studies suggest that in reality, people's discount rates do
decline over time. Because cost–benefit analysis aims to measure the public's true
willingness to pay, this feature is typically built into studies.
During cost–benefit analysis, monetary values may also be assigned to less tangible
effects such as the various risks that could contribute to partial or total project failure,
such as loss of reputation, market penetration, or long-term enterprise strategy
alignments. This is especially true when governments use the technique, for instance
to decide whether to introduce business regulation, build a new road, or offer a new
drug through the state healthcare system. In this case, a value must be put on human
life or the environment, often causing great controversy. For example, the cost–
benefit principle says that we should install a guardrail on a dangerous stretch of
mountain road if the dollar cost of doing so is less than the implicit dollar value of the
injuries, deaths, and property damage thus prevented (R.H. Frank 2000).
Cost–benefit calculations typically involve using time value of money formulas. This
is usually done by converting the future expected streams of costs and benefits into a
present value amount.