by John Roman
What is it used to measure?
Cost-benefit analysis (CBA) is a comparative method for measuring changes in net social welfare resulting from government intervention into a private marketplace. Intervention into markets is undertaken in the case of a market failure, when the market price of a good or service does not include all relevant social costs. A typical CBA might study a change in environmental regulation, for example, when costs of producing a good (such as paper) does not include costs to others who are not part of the market transaction (such as costs from pollution). As a result, more paper and hence more pollution will be produced than would have if the cost to society from pollution were included in the price. The intervention might increase taxes to increase the price of paper, decrease pollution, and thereby create a more efficient marketplace. A CBA would test whether positive outcomes from reduced pollution outweigh losses to producers and consumers from higher paper costs. CBA is routinely used to study changes in health, education, welfare, employment, crime, environmental, and tax policies.
How does it work?
In neoclassical welfare economic studies, costs and benefits are estimated from changes from an intervention in the supply and demand for a good or service. For example, the costs of the pollution intervention include project expenditures and lost consumer and producer surplus for buyers and sellers. Benefits are measured as the reduction in pollution-related costs for those who experience pollution but did not buy or sell paper. Transfers from consumers and producers to third parties produce no overall change in welfare. Net social welfare change (the primary outcome of CBA) is measured as the costs of the intervention compared to the overall change in welfare for society: consumers, producers, and third parties.
CBA requires that supply and demand be either directly observed or derived from other markets. Costs are defined as program or policy inputs, and benefits are defined as program or policy outcomes. In cost analysis, a price is estimated for each unit of input, which could be a service (such as an hour of training for paper factory workers) or a good (such as the cost of a machine to scrub emissions). The quantity of inputs (such as total hours of training and total number of machines) are estimated. Prices and quantities are multiplied to yield a total cost for each input, which are summed to yield a total cost estimate. Costs are estimated for both the pre- and post-intervention markets. The general analytical approach is the same for measuring benefits, except that prices and quantities of outcomes (such as public health) rather than inputs are estimated. Results can be presented as a ratio (costs per benefit) or as the net welfare change (the difference between costs and benefits).
While CBA can be used to evaluate a program’s costs compared to its benefits, it is mainly employed to compare two or more approaches to a single problem. Estimates of prices can usually be directly observed, but estimating quantities of inputs and outcomes often requires a rigorous impact evaluation, employing either an experimental design or a quasi-experimental design.
The value of CBA is that all outcomes are presented in a standardized unit, generally dollars, that allows for objective comparisons across disparate interventions. While the idea of comparing costs and benefits is intuitive, in practice cost-benefit analysis often requires complex and nuanced assumptions for valuing the costs and benefits for goods and services that do not have an accessible market analogue. Cost-benefit studies of health (what is the value of reduced pain?), the environment (what is the value of clean air?), and crime (what is the value of reduced fear?) are particularly challenging.
Research examples
"Benefit-Cost Analysis of Supermax Prisons"
"Evaluation of the D.C. Superior Court Drug Intervention Program"
"The Economics of Juvenile Jurisdiction"
