Cost Benefit Analysis and the Environment*

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What is Cost-Benefit Analysis?

Cost-Benefit Analysis (CBA) originated in the area of research called welfare economics.  It helps to answer questions about the benefit of one outcome over another, from a societal standpoint.  Welfare economics uses criterion from the Utilitarian philosophy of the eighteenth century.  These researchers tried to "compare outcomes on the basis of what gives the greatest benefit to the greatest number of people.  Benefit here means utility: thus, welfare economics looks at ways of comparing outcomes in terms of their contribution to the utility of the population as a whole" (Hanley, 69).  The value of environmental costs and benefits are most clearly understood when represented in monetary units, and then balanced against one another.

Stages of Cost-Benefit Analysis:

1. Defining the Project or Policy  As well as identifying the choice that will be analyzed, economists must recognize whose welfare is being considered and the time period in question.

2. Identifying Physical Impacts of the Policy or Project  Identify (in units) the implications of the outcomes.  Examples of this would include: 500 human labor hours required to carry out the project or 3 billion tons of reduced landfill pollution 

3. Valuing Impacts  Value the impact of a specific action or inaction in terms of its marginal social cost or marginal social benefit.  For in-depth information on valuation, follow the link. 

4. Discounting of Cost and Benefit Flows  A very important concept to realize with CBA is that a benefit is considered more valuable the sooner it is received.  In the same way, a cost is considered less detrimental the further way in time it is incurred.  For this reason all costs and benefits must be discounted to reflect present values.  It would be inappropriate to compare receiving one million dollars today and receiving one million dollars in 75 years as being equal.  A discount rate is used to translate future values into present values.    

5. Applying the Net Present Value Test  Net Present Value (NPV) equals the sum of the benefits in present value minus the sum of the costs in present value.  The project should be accepted if the NPV>0.  In other words, if the discounted benefits is greater than the discounted costs, the project should be accepted.

6. Applying Sensitivity Analysis  Analysis of this kind refers to "recalculating NPV when the values of certain key parameters are changed" (Hanley, 79).  Since there is uncertainty in CBA it is important to know for which parameter the NPV is most sensitive.  An example would be if a firm installs 3 filters to reduce water pollution and the pollution is reduced by 30%.  Sensitivity analysis would look at the affects of a change in the number of filters.  If 4 filters reduced the water pollution by 70%, that would be a very large indicator that the percentage of water pollution is very sensitive to the number of filters.  Hanley refers to the common parameters that should be reviewed which include:

• the discount rate
• physical quantities and qualities of inputs
• physical quantities and qualities of outputs
• project lifespan

Advantages of CBA 

• A variety of different impacts can be measured in the same units
• Can be used as a device for determining where limited funding and resources should be directed.
• Takes into account both direction and intensity of preferences.
• "Allows us to emphasize both the economic value of environmental protection as well as the opportunity cost of protecting the environment" (Hanley, 72)

Problems and Questions that Arise when Applying CBA to the Environment:

• How to determine value for the environment.  Is it immoral to place monetary values on things such as wildlife?
• It is very difficult to predict the effects of a single change on an entire ecosystem.  An understanding of the ripple effects of a certain policy on the environment is often uncertain.
• Is it appropriate to discount future costs and benefits and if so, what should the discount rate be?
• Can the CBA be manipulated to reflect the interests of firms?
• CBA does not test sustainability. So does CBA, with discounted benefits and costs, give future generations the short shrift?
  

 

*The information in this section was summarized during a study of the following text: Hanley, Nick, and Jason F. Shogren and Ben White. Introduction to Environmental Economics. New York: Oxford University Press, 2001.