Omission Error
the analyst fails to include an impact that happens (false-negative) or mistakenly includes one the does not happen (false-positive)
Measurement Error
if an impact is observed to be larger than the analyst forecasted, the intial estimate was an underprediction; overpridiction is the opposite, and the observed impact is smaller than estimated
Timing Error
accurate estimates for the timing of an impact are essential, because future impacts are discounted at the public sector discount rate; the sooner an impact occurs, the less its value is impacted by the PSDR.
Nine Steps of CBA
- select the set of alternatives
- define the referent group
- catalogue potential impacts and select measurement indicators
- predict quantitative impacts over the life of the projects
- monetize all impacts
- discount all costs and benefits and calculate net present value
- describe the distribution of costs and benefits
- analyze the effects of uncertainty
- make a recommendation
Select the Set of Alternatives
most CBA’s will consider a small number of alternatives due to resource and cognitive constraints. the NPV of alternatives is measured against a counterfactual.
Counterfactual (Base Case)
the counterfactual is the reference against which alternatives will be compared. the most plausible stiuation should be chosen (the “business as usual” case) as the counterfactual.
Define the Referent Group
the referent group is the collection of individuals with standing in a given CBA. most CBAs will consider two referent groups - one global and one at the level of the state which has commissioned the analysis. although choice of referent group is subjective, it has important implications on analytical outcomes.
Financial Transfers
financial transfers must be treated differently depending on whether they stay within the referent group or cross its boundaries. transfers between members are neither a cost or benefit, although they should still be recorded to (1) analyze distributional impacts of the policy change in case projects are to be evaluated on a criterion other than their aggregate efficiency and (2) because additional impacts may be generated as a side-effect of the transfer (changing the incentives faced by producers and consumers for example)
Catalogue Impacts and Select Measurement Indicators
the term impacts is used broadly to refer to both inputs and outputs. an inventory of the impacts that are expected to occur as a result each policy is created, and categorized as benefits or costs.
Predict Quantitative Impacts Over the Life of the Project
predections are made in the units of the event which they are trying to predict. impacts are measured as incremental changes from the counterfactual, and the timing of the impacts is an important element of the prediction / measurement.
Monetize All Impacts
impacts must be converted to a common monetary unit before they can be aggregated. non-financial impacts may be hard to value because (1) there is no market for the impact; (2) the market is distorted; (3) or the project affects market prices.
Discount All Costs & Benefits; Calculate NPV
future monetary values can not be directly compared to present values, and future values must be discounted for the time value of money. a cost or benefit that occurs in year t is converted to its present value by dividing it by (1 + s)^t, where s is the social discount rate. future values that have been discounted are called present values.
Analyze Effects of Uncertainty
predictions of future impacts contain uncertainty. in theory uncertainty should be directly accounted for when assigning value to those impacts; however a sensitivity analysis is used to illustrate the risk - for example, show the values of a parameter that would change the policy recommendation.
Make a Recommendation
choose the project with the largest NPV; the analyst can act as if society is risk-neutral in making his recommendation
CBA vs Profit-Loss (Financial) Analysis
- CBA exists to inform governments about the impact of changing their policies (redistributing collectively held resources) on the amount and distribution of social surplus; PLA determines the profit-maximizing policy for a business
- a PLA considers the financial impacts, whereas a CBA is not a financial analysis (although it incorporates one); CBA assesses all monetary and non-monetary impacts to consider the efficiency case for a policy change
- the referent group for the CBA is society as a whole which, even when defined narrowly, is much broader than the referent group of a PLA, which is the shareholders of the company in question
- PLA uses the private sector discount rate; CBA uses the public sector (or social) discount rate which will account for the rate of time preference at which consumers discount future consumption
Arrow’s Impossibility Theorem
we can not measure and compare the utility preferences of individuals; yet, equally, any social choice rule that satisfies the axioms of
1. unrestricted domain (any set of individual rankings)
2. pareto choice
3. independence (from irrelevent alternatives)
4. non-dictatorship
cannot guarantee a social ranking that is complete, reflexive (a bundle is at least as good as itself), and transitive.
Utilitarianism
the concept of utilitarianism suggests that we take actions that yield the greatest amount of benefit to the greatest amount of people; a utilitarian ethic suggests that we should aggregate up utility (choose policies such that individual utilities sum to their highest possible value). utility can not actually be measured, and is not an actionable premise, so welfare analysis is conducted using the concept of social surplus.
Pareto Dominant
an allocation that results from a PI is said to pareto dominate the previous allocation; resource allocations can be ranked only if one pareto dominates the other (and therefore we can conclude utility has increased)
Pareto Frontier
the set of all PE resource allocations. the section of the frontier that are PIs relative to the initial allocation is the Pareto core. a Pareto efficient outcome is not necessarily social-surplus maximizing.
Kaldor-Hicks Criterion
- a reallocation that creates winners and losers such that the winners could in principle make a transfer to fully compensate the losers and still be better off than in the base case should be adopted; this criterion is the guiding normative rule of CBA
- where policies enhance or interfere with one another, the policy or combination of policies which produces the largest increase in social surplus should be chosen
- DOES NOT MEAN that aggregated social utilitiy is higher, that the new allocation is more efficient, or that it maximizes social surplus; however we CAN SAY social surplus has increased
Willingness to Trade
in order to assign monetary values to non-monetary impacts the concept of willingness to trade will be used. WTP is used if the person is assumed not to have a right to the utility they will receive/lose; however WTA is used when the person is assumed to have a right to the utility.
Economic Reasons for CBA
CBA attempts to improve social welfare - specifically, to maximize allocative efficiency. where markets function well, this is unnecessary, but where there is market failure, CBA analyzes whether intervention is more efficient. conversely, government failures (when intervention decreases efficiency) can be analyzed to find if a new policy is more efficient than the existing one.
CBA: Potential Issues
- Undermines political process by imposing the single goal of efficiency
- Places monetary value on “priceless” things such as life
- The ranking of policies in terms of NPV does not gaurantee a transitive social ordering of the policies
- wealth distribution affects WTP of individuals - hypothetically a policy with positive NPV could lower utility due to the differing marginal utility of money of individuals
- individuals may be affected who do not have standing in the CBA
Public Sector Discount Rate
also known as the social discount rate. used to compute the present value of future costs or benefits of project impacts - crucial when impacts differ over time. the benefit or cost per dollar can be calculated by 1 / [(1 + r)^2]
