Is cost-benefit analysis really beneficial?

Tags: Op-ed
Is cost-benefit analysis really beneficial?
MUMBO JUMBO: Cost-benefit analysis fails to produce the greater objectivity and transparency promised by its proponents. It rests on a series of assumptions and value judgments that cannot remotely be described as objective
The critique of economic theory is not just a textbook problem but has a wider scope. Policy analyses and economics demands the use of cost-benefit analysis (CBA); however, this elegant technique suffers from a number of problems.

For example, essential for evaluation of health and environmental protection, consider this exploitation of cost-benefit analysis in the US. John Graham, formerly head of the Harvard Centre for Risk Analysis, was the Bush administration’s cost-benefit analysis “czar.” He was assigned to test regulations proposed by federal agencies just to be sure that the costs do not exceed the benefits. Graham had often suggested federal agencies to make revisions or do additional analyses, when he decided that the proposed rules would not pass a cost-benefit test. Naturally, the end result has been a slowing-down and waning of environmental protection. When cost-benefit analysis is so sound and easy, then why shouldn’t we check that the benefits exceed the costs before adopting a new regulation?

The first step in a CBA is to calculate the costs of a public policy. The costs of protecting human health and the environment through the use of pollution control devices and other approaches could be measured in rupees or dollars. Thus, at least in theory, the cost side of cost-benefit analysis is relatively straightforward. (In practice, it is not that simple, and often costs are dramatically overstated in advance of regulation).

More problematic, however, is the second step in the analysis: monetising the benefits achieved by the regulation. Since there are no natural prices for a healthy environment, CBA requires the creation of artificial ones. Economists create artificial prices for health and environmental benefits by studying what people would be willing to pay for them. One popular method, called “contingent valuation,” is essentially a form of opinion poll. Researchers ask a cross-section of the affected population how much they would be willing to pay to preserve or protect something that can’t be bought in a store.

An alternative method of attaching prices to unpriced things infers what people are willing to pay from observation of their behaviour in other markets. To assign a dollar value to risks to human life, for example, economists usually calculate the extra wage that is paid to some workers who accept more risky jobs. If workers understand the risk and voluntarily accept a more dangerous job, then they are implicitly setting a price on risk by accepting the increased risk of death in exchange for increased wages. What does this indirect inference about wages say about the value of a life? A common estimate in recent cost-benefit analyses is that avoiding a risk that would lead, on average, to one death is worth roughly $6.3 million. Finally, costs and benefits of a policy frequently occur at different times. Often, costs are incurred in the near future to prevent harm in the more remote future. When the analysis spans a number of years, future costs and benefits are discounted, or treated as equivalent to smaller amounts of money in today’s rupees or dollars.

Moving beyond the comforts of an easy theory, it can be shown that CBA of regulations fails on a number of grounds. First, cost-benefit analysis cannot produce more efficient decisions because the process of reducing life, health, and the natural world to monetary values is inherently flawed.

Efforts to value life illustrate the basic problems. CBA implicitly equates the risk of death with death itself, when in fact they are quite different and should be accounted for separately in considering the benefits of regulatory actions. CBA also ignores the fact that citizens are concerned about risks to their families and others as well as themselves, ignores the fact that market decisions are often very different from political decisions, and ignores the incomparability of many different types of risks to human life.

Secondly, use of discounting systematically downgrades the importance of environmental regulation. While discounting makes sense in comparing alternative financial investments, it cannot reasonably be used to make a choice between preventing harms to present generations and preventing similar harms to future generations. Nor can discounting reasonably be used even to make a choice between harms to the present generation; choosing between preventing an automobile fatality and a cancer death does not turn on prevailing rates of return on financial investments. In addition, discounting tends to trivialise long-term environmental risks, minimising the very real threat our society faces from potential catastrophes and environmental harms, such as those posed by global warming and nuclear waste. Significantly, all of the studies suggesting that regulation kills people because it is so expensive employed discounting, which caused regulatory benefits to appear to shrink and regulatory costs to grow.

Thirdly, cost-benefit analysis ignores the question of who suffers as a result of environmental problems and, therefore, threatens to reinforce existing patterns of economic and social inequality. In fact, poor countries, communities, and individuals are likely to express less “willingness to pay” to avoid environmental harms, simply because they have fewer resources. Therefore, cost-benefit analysis would justify imposing greater environmental burdens on them than on their wealthier counterparts. With this kind of analysis, the poor get poorer.

Finally, cost-benefit analysis fails to produce the greater objectivity and transparency promised by its proponents. It rests on a series of assumptions and value judgments that cannot remotely be described as objective. A popular old joke describes economists as seeing something working in practice, and asking whether it is possible in theory. As researchers rightly point out, in this case, the joke is being told in reverse: having established that CBA of environmental protection is impossible in theory, its advocates have set out to see if it works in practice.

(The writer is on the faculty of Indian Institute of

Technology, Mandi, India)


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