Why is Cost-Benefit Analysis So Controversial?

1. Why is Cost-Benefit Analysis So Controversial? Robert Frank

2. The Cost-Benefit Analysis Principle • CBA: The right action, from a set of alternatives, is the action whose benefits exceeditscosts. • Standard view – CBA is an undeniable principle, it is unobjectionable. • Question: Is CBA a necessary or sufficient condition on right action and policy adoption? • Necessary Condition: If x is the right action, then xis such that the benefits of adopting it outweigh the costs. • Sufficient Condition: If x is such that the benefits of adopting it outweigh the costs, then x is the right action. • As a necessary condition CBA sounds unproblematic. As a sufficient condition it maybe problematic, since other factors may override choosing an action on the basis of CBA alone.

3. Cost Effective Analysis vs. Cost Benefit Analysis • Cost Benefit Analysis says we should choose the action or policy whose benefits outweigh the costs. • Cost Effective Analysis says, given an end E, we should bring about E in the most cost effectivemanner. • The distinctionbetween the two is given by contrasting CBA and CEA. • One might say that we decide whether or not to do action A or bring about policy P based on CBA or a democratic vote. It is possible that although P is chosen through democratic vote, the costs of P are greater than the benefits of P. • CEAwould then say:now that we have chosen P, we should bring about P in the most cost effective way.

4. CBA and the Incommensurability Problem • CBA says 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 prevented. • Critics would argue that putting a dollar value on human life is illegitimate. The implication being that we should put the guardrail there no matter what the cost. • However, given that resources are scarce we cannot ignore the cost. For it maybe better for us to use the money that could be used to make the guardrail for some other end that is also of value. • For example, we might choose to use the $1000.00 needed for the guardrail to fund a safe driving program which would reduce the number of deaths due to driving more than the number of deaths due to the lack of a guardrail. • If resources are unlimited, then it makes sense to ignore the cost of the guardrail relative to other interventions. But it makes no sense in times of scarcity.

5. CBA and Consequentialist Ethics • Some critics maintain that CBA rests on consequentialist ethics, which maintains that the right action, from a set of available actions, is that action that maximizes aggregate happiness. • Thus, one technique that can be used to argue against CBA is to show that consequentialist ethics is problematic. • There are several ways one can show that consequentialist ethics is problematic: • Argue against the principle of hedonism, which maintains that pleasure is the only thing of intrinsic value. • Argue against Sum Ranking Welfarism, which maintains that A is better than B if and only if the sum of pleasure in A is greater than in B. • Argue against act-consequentialism, which maintains that the right action is the action whose consequences are better than every other alternative action’s consequences.

6. CBA and Discounting the Future • CBA puts all relevant costs and benefits on a common temporal footing. It determines the value of future costs and benefits in present value terms. • In order to take a future consequence into account in the present one must apply a discount rate, which is often the insurance rate given by financial markets. • However, subjective utility appears to be different from money. A present pain or pleasure is always more significant that a future pain or pleasure. While it might be possible to reduce future costs and benefits to present via discount rates, it is harder to do so with pain or pleasure. • Having been born later should not mean that one’s enjoyment or suffering counts less. When adopting a policy we should take into account future generations. • CBA is not really objectionable on the basis of future discounting.

7. CBA and Distributional Issues • CBA uses willingness-to-pay. Willingness-to-pay is based on income. And because high-income people have more disposable income than low income people, the metric of willingness-to-pay gives more power to high-income people. • Implicit assumption of the objection is that everyone’s preferences regarding policy decisions should be considered irrespective of income. • Suppose one rich person and two poor people are deciding on policy P. The rich person is willing to pay 1000 for policy P, while the two poor are willing to pay 100 each to prevent P. If we use equal weighting regardless of willingness-to-pay, then P does not get implemented. However, there is an 800 dollar loss. • Further suppose, that we could take 500 from the 800 and give it back to the the poor. Would we still oppose the implementation of policy P? • Should policy decisions give equal weighting to people irrespective of income?

8. CBA and Measurement Problems • To use CBA, we need to be able to measure costs and benefits. • Survey methods use surveys to determine what people think of the costs and benefits. • Hedonic methods attempt to infer valuations from actual market-behavior. • Both approaches have problems.

9. Survey Methods • Survey methods ask questions, such as: How much is the preservation of a virgin redwood forest worth? Proponents of the contingent-valuation method generate estimates by asking people how much they are willing to pay to see the forest preserved. • Valuations are implausibly large. • Survey’s have framing effects. • Respondents are often willing to pay more by several orders of magnitude to prevent a harmful effect than to undo a harmful effect that has already occurred.

10. Hedonic Methods • Given the problems in the survey methodology, people have turned to Hedonic Pricing Models. • Hedonic pricing models attempt to infer valuation from actual market behavior. For example, analysts estimate the value of noise reduction by examining how residential housing prices vary with ambient noise levels, or the value of safety by examining how wages vary with workplace injury levels. • Does the work-safety gradient tell us how much workers value safety? • It seems that the argument in favor of this position rests on the invisible hand. • However, since the market does not contain perfect information, we cannot determine that the work-safety gradient does tell us how much workers value safety.

11. Impulse Control Problems and Revealed Preference • Hedonic pricing models assume we can infer the values people place on future events by observing the choices they make. • For example, if a person accepts a one in 10 chance of contracting a serious illness 1 year from now in return for a payment of $100 now, then the cost of taking that risk, expressed as a present value, cannot be more than $100. • Hedonic pricing models predict that people will choose similarly from choices (a) and (b). (a) $100 tomorrow versus $105 a week from tomorrow (b) $100 after 52 weeks versus $105 after 53 weeks. However, most pick the $100 option in (a) and the $105 option in (b). Experimental evidence suggests that people do not discount the future exponentially, but rather hyperbolically.

12. Impulse Control and Revealed Preference How people deal with impulse control: • Anticipating their temptation to overeat, people often try to limit the quantities of sweets, salted nuts, and other things they keep in their house. • Anticipating their temptation to spend cash in their checking account, people enroll in payroll deduction savings plans. • Reformed smokers seek the company of nonsmokers. • Recovering alcoholics avoid cocktail lounges. How the problem persists: • Many people continue to express regret about having overeaten, having drunk too much, and smoked to much, and saved too little. • The exponential discounting model urges us to dismiss these expressions as sour grapes. • The hyperbolic discounting model makes these expressions coherent. • In each the actor chose an inferior option when a better one was available, and later feels genuinely sorry about it.

13. Status Quo Bias Opposition to CBA also stems from the fact that costs of policy change are often far easier to quantify than benefits, especially in environmental policy and health and safety policy. In both fields, consensus about how to measure benefits has proved especially elusive. The upshot is that policy decisions in these arenas tend to be driven primarily by cost considerations, resulting in a bias in favor of the status quo. The fact that benefits are more difficult to measure than costs does not provide a compelling reason to abandon cost-benefit analysis. Just as the fact that costs are easier to forecast than revenues does not provide a compelling reason for firms to abandon profit maximization. In each case, we do better to act on the best information available than to act on no information at all.

14. Conclusion 1 Critics of CBA have failed to offer persuasive arguments that cost-benefit analysis is objectionable as a matter of principle. Of the objections considered here none present an in principle problem that cannot be solved. In addition, CBA should not be abandoned if there is no other alternative that can provide an equally valuable decision tool.

15. Conclusion 2 • Many of the methods used by cost-benefit analysis generate systematically biased prescriptions. • Hedonic pricing methods overstate the value of goods and activities whose demands are relatively context sensitive. They give too much weight to current costs and benefits, and too little weight to those that occur in the future. • CBA as currently practiced maybe controversial simply because it often generates misleading prescriptions.