Cost–benefit analysis Study Guide

📖 Core Concepts Cost‑Benefit Analysis (CBA) – systematic comparison of total monetary benefits vs. costs of a project or policy to decide if the net benefit is positive. Net Present Value (NPV) – sum of discounted benefits minus discounted costs over the project horizon. Discount Rate – reflects time preference and opportunity cost; a higher rate gives less weight to future values. Kaldor–Hicks Criterion – a policy is efficient if those who gain could, in theory, compensate those who lose and still be better off. Consumer Surplus – benefit when a person’s willingness to pay exceeds the price paid. Distributional Weights – factors that give extra importance to benefits received by specific groups (e.g., low‑income households, future generations). Social Welfare Function – aggregates individual utilities into a societal welfare measure (e.g., Bergson‑Samuelson). 📌 Must Remember CBA Formula: $$NPV = \sum{t=0}^{T} \frac{Bt - Ct}{(1+r)^t}$$ where \(Bt\) = benefit at time \(t\), \(Ct\) = cost at time \(t\), \(r\) = discount rate, \(T\) = final year. Decision Rule: Choose the alternative with the highest positive NPV (or the least negative if all are < 0). Discount Rate Choice: Social discount rate → used for public projects, emphasizes intergenerational equity. High rate → undervalues long‑term benefits (e.g., climate mitigation). Low/declining rate → gives more weight to distant future outcomes. Distributional Adjustment: Apply income‑based weights or “one‑person, one‑vote” scaling to reflect diminishing marginal utility of income. Sensitivity Analysis: Test robustness by varying key assumptions (discount rate, income elasticity, probability distributions). 🔄 Key Processes Define objectives of the proposed action. List alternatives and identify stakeholders. Select measurement units; quantify every cost and benefit. Forecast outcomes over the relevant time horizon. Convert to common monetary units (use market prices, stated/revealed preference methods). Apply discount rate to obtain present values. Calculate NPV for each alternative (use the formula above). Perform sensitivity analysis (vary discount rate, probabilities, etc.). Interpret results and adopt the recommended alternative. 🔍 Key Comparisons Cost‑Benefit vs. Cost‑Effectiveness – CBA uses monetary valuation for all outcomes; Cost‑Effectiveness uses a non‑monetary metric (e.g., energy saved per dollar). Cost‑Utility vs. Cost‑Benefit – Cost‑Utility measures benefits in QALYs/ DALYs (health outcomes) rather than dollars. Stated‑Preference vs. Revealed‑Preference – Stated: surveys directly ask willingness to pay; Revealed: infer willingness to pay from actual market behavior. High vs. Low Discount Rate – High: favors present‑day projects, downplays distant benefits; Low: emphasizes long‑term/ environmental projects. ⚠️ Common Misunderstandings “CBA ignores distribution” – It can incorporate distributional weights; the basic Kaldor‑Hicks test alone ignores equity, but extensions exist. “Discounting always unfair to future generations” – Not always; a declining or zero discount rate can be used for long‑term environmental benefits. “All benefits must be monetary” – Non‑monetary valuations (QALYs, ecosystem services) can be integrated via cost‑utility or multi‑criteria analysis. 🧠 Mental Models / Intuition “Money today vs. money tomorrow” – Think of discounting like “interest earned”: a dollar tomorrow is worth less because you could invest it now. “Compensating the losers” – If the winners could theoretically pay the losers and still be ahead, the project passes the Kaldor‑Hicks test. “Weight the poor more” – A dollar to a low‑income person → larger utility; applying income‑based weights balances the scale. 🚩 Exceptions & Edge Cases Climate‑related benefits – May justify a zero or near‑zero discount rate to avoid undervaluation. Non‑market goods (e.g., cultural heritage) – Require contingent valuation or deliberative methods; standard market prices unavailable. High uncertainty – Use Monte Carlo simulation to model combined uncertainties across many variables. 📍 When to Use Which Monetary outcomes readily observable → Use standard CBA with NPV. Non‑monetary outcomes dominate (e.g., health, energy) → Prefer Cost‑Effectiveness or Cost‑Utility analysis. Strong equity concerns → Apply distributional weights or income‑based adjustments. High uncertainty or many stochastic inputs → Conduct Monte Carlo simulation and sensitivity analysis. 👀 Patterns to Recognize Positive NPV but high discount rate → Likely undervalues long‑term environmental benefits → double‑check discount choice. Large benefit variance in Monte Carlo output → Indicates key risk drivers; focus sensitivity tests there. Disproportionate benefit to high‑income groups → Trigger consideration of distributional weights or “one‑person, one‑vote” adjustments. 🗂️ Exam Traps Choosing the highest gross benefit instead of highest NPV – forgetting to discount costs and benefits. Assuming a single “right” discount rate – exam may ask why a lower or declining rate is appropriate for climate projects. Confusing Cost‑Effectiveness with Cost‑Benefit – remember CEA uses non‑monetary units; CBA requires monetary conversion. Ignoring sensitivity analysis – a result that changes dramatically with a slight discount‑rate tweak signals a weak conclusion. Over‑relying on Kaldor‑Hicks – may be a distractor if the question emphasizes equity; you need to discuss distributional weights.