Cost Benefit Analysis (CBA) as the name suggests, is a techniques in which we analyse the costs involved and benefit expected in any given project, decision, policy etc. If benefits exceed the costs, accept it as it is efficient. If it is other way round, reject it. CBA can be used to measure not only monetary costs and benefits but the element of non-monetary cost and non-monetary benefits can also be incorporated.
Somewhere, profits are the one most important criterion to accept or reject a project. Profits are the difference between costs and benefits. But an important point to be noted is that costs are to be incurred in the present but benefits will flow only in the future. However, some costs may also be involved for the future. Therefore we need to calculate Net Present Value (NPV) of the benefits expected. Even NPV of various possible projects have to be compared to choose the best available option.
Discounting The Future
When we do cost-benefit analysis, the costs involved may have to be incurred in the present or future. Similarly the expected benefits also take place in the future. This gives rise to the problem of an appropriate discounting factor that gives us the accurate present value of the future costs and benefits. NPV can give us the net present value of future benefits but social rate of discount is different from market rate of discount. When there is involvement of government and existence of taxes, the rate that is applicable is:
ΔS(1 +r) + { ΔC(1+r) /(1—t)}— ΔS — ΔC/ ΔS + ΔC.
Where r is rate of interest;
T is rate of tax;
S is savings
C is consumption.
There are other problems also in estimating social discount rate:
(a) Returns for future period are not known for certain.
(b) Some costs can be known only once the project is over. For example, cost of cultural erosion.
(c) Some social benefits are also conceivable only on the completion of the project. For example, creating awareness for any disease.
Sometimes, when individuals themselves do not invest in education or health, as they may not be sure of the benefits, it is advisable that the government should provide for subsidized education or free health care to avail of the benefits that the whole society will get from this investment.
Distributional Concerns
While doing cost benefit analysis of any project, we must also consider the impact of the project on distribution of income. Whether it will benefit well off section more leading to increase in inequalities of income; or the poorer section and thereby reducing inequalities of income; or the benefits are being shared equally. According to Alfred Pareto, if any project makes someone better off without making anyone else worse off it should be accepted. But if poor section remaining at the same level and richer section is better off by a project, inequalities of income will increase. It will have welfare implications for the project. For example, the recently launched Reliance Metro in Delhi, might not have worsened the poor section and have better off the well off section but the same funds had an opportunity cost. Marginal utility is more for the poor than rich. Utilitarian approach suggests that the project which brings maximum good to maximum people is most efficient. Any project which makes poor section worse off has imposed a social costing terms of class struggle and increased crime rate. According to Rawlsian perspective, a project is worth if it benefits the poorest of the poor section of the society. Hence, both utilitarian perspective and Rawlsian approach strongly recommends that the transfer of resources from the luxuries of the rich to the basic needs of the poor will maximize the gains of the society.
Cost Benefit Analysis (CBA) as the name suggests, is a techniques in which we analyse the costs involved and benefit expected in any given project, decision, policy etc. If benefits exceed the costs, accept it as it is efficient. If it is other way round, reject it. CBA can be used to measure not only monetary costs and benefits but the element of non-monetary cost and non-monetary benefits can also be incorporated.
Somewhere, profits are the one most important criterion to accept or reject a project. Profits are the difference between costs and benefits. But an important point to be noted is that costs are to be incurred in the present but benefits will flow only in the future. However, some costs may also be involved for the future. Therefore we need to calculate Net Present Value (NPV) of the benefits expected. Even NPV of various possible projects have to be compared to choose the best available option.
Discounting The Future
When we do cost-benefit analysis, the costs involved may have to be incurred in the present or future. Similarly the expected benefits also take place in the future. This gives rise to the problem of an appropriate discounting factor that gives us the accurate present value of the future costs and benefits. NPV can give us the net present value of future benefits but social rate of discount is different from market rate of discount. When there is involvement of government and existence of taxes, the rate that is applicable is:
ΔS(1 +r) + { ΔC(1+r) /(1—t)}— ΔS — ΔC/ ΔS + ΔC.
Where r is rate of interest;
T is rate of tax;
S is savings
C is consumption.
There are other problems also in estimating social discount rate:
(a) Returns for future period are not known for certain.
(b) Some costs can be known only once the project is over. For example, cost of cultural erosion.
(c) Some social benefits are also conceivable only on the completion of the project. For example, creating awareness for any disease.
Sometimes, when individuals themselves do not invest in education or health, as they may not be sure of the benefits, it is advisable that the government should provide for subsidized education or free health care to avail of the benefits that the whole society will get from this investment.
Distributional Concerns
While doing cost benefit analysis of any project, we must also consider the impact of the project on distribution of income. Whether it will benefit well off section more leading to increase in inequalities of income; or the poorer section and thereby reducing inequalities of income; or the benefits are being shared equally. According to Alfred Pareto, if any project makes someone better off without making anyone else worse off it should be accepted. But if poor section remaining at the same level and richer section is better off by a project, inequalities of income will increase. It will have welfare implications for the project. For example, the recently launched Reliance Metro in Delhi, might not have worsened the poor section and have better off the well off section but the same funds had an opportunity cost. Marginal utility is more for the poor than rich. Utilitarian approach suggests that the project which brings maximum good to maximum people is most efficient. Any project which makes poor section worse off has imposed a social costing terms of class struggle and increased crime rate. According to Rawlsian perspective, a project is worth if it benefits the poorest of the poor section of the society. Hence, both utilitarian perspective and Rawlsian approach strongly recommends that the transfer of resources from the luxuries of the rich to the basic needs of the poor will maximize the gains of the society.