Friday, July 17, 2009

Cost-benefit analysis in policy making

Cost-benefit analysis (CBA) is one of the oldest methods of evaluating a project or a proposal or a policy. Standard economic theories claim that economic efficiency, measured by the difference between benefits and costs, should be the touchstone for making policy choices.

In recent years there has been an interesting debate about its utility in evaluating social and welfare policies and environmental regulations. Opponents point to the difficulty in identifying, quantifying and monetizing the marginal costs and benefits associated with these policies. They argue that such policies suffer from numerous externalities, both positive and negative, that are outside the framework of quantifiable parameters. Further, CBA is silent about issues like fairness and processes and distribution of costs and benefits. Regulatory policies with aggregate benefits exceeding aggregate costs will also have winners and losers.

Prof Robert Stavins points to an old article which examines whether there is role for benefit-cost analysis in environmental, health, and safety regulation. They gave eight principles on the appropriate use of CBA

1. CBA can be useful for comparing the favorable and unfavorable effects of policies, because it can help decision makers better understand the implications of decisions by identifying and, where appropriate, quantifying the favorable and unfavorable consequences of a proposed policy change. But, in some cases, there is too much uncertainty to use benefit-cost analysis to conclude that the benefits of a decision will exceed or fall short of its costs.

2. Decision makers should not be precluded from considering the economic costs and benefits of different policies in the development of regulations. Removing statutory prohibitions on the balancing of benefits and costs can help promote more efficient and effective regulation.

3. BCA should be required for all major regulatory decisions. The scale of a benefit-cost analysis should depend on both the stakes involved and the likelihood that the resulting information will affect the ultimate decision.

4. Although agencies should be required to conduct CBA for major decisions, and to explain why they have selected actions for which reliable evidence indicates that expected benefits are significantly less than expected costs, those agencies should not be bound by strict benefit-cost tests. Factors other than aggregate economic benefits and costs may be important.

5. Benefits and costs of proposed policies should be quantified wherever possible. But not all impacts can be quantified, let alone monetized. Therefore, care should be taken to assure that quantitative factors do not dominate important qualitative factors in decision making. If an agency wishes to introduce a "margin of safety" into a decision, it should do so explicitly.

6. The more external review that regulatory analyses receive, the better they are likely to be. Retrospective assessments of selected regulatory impact analyses should be carried out periodically.

7. A consistent set of economic assumptions should be used in calculating benefits and costs. Key variables include the social discount rate, the value of reducing risks of premature death and accidents, and the values associated with other improvements in health.

8. While CBA focuses primarily on the overall relationship between benefits and costs, a good analysis will also identify important distributional consequences for important subgroups of the population.

The authors write, "Although formal benefit-cost analysis should not be viewed as either necessary or sufficient for designing sensible public policy, it can provide an exceptionally useful framework for consistently organizing disparate information, and in this way, it can greatly improve the process and, hence, the outcome of policy analysis. If properly done, benefit-cost analysis can be of great help to agencies participating in the development of environmental, health, and safety regulations, and it can likewise be useful in evaluating agency decision-making and in shaping statutes."

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