Cost-Benefit Analysis as a Failure to Learn from the Past.

Author:Broughel, James
  1. Introduction

    Cost-benefit analysis (CBA) is a tool widely used in the US federal government and around the world to evaluate the welfare properties of public policies. Economists across the political spectrum endorse CBA as a useful tool to guide decision-making. However, CBA suffers from a number of shortcomings that in other contexts would be thought of as elementary failures to apply basic economic principles. This brief note will outline these shortcomings.

    For whatever reason, CBA has not absorbed many lessons learned throughout the history of economic thought, lessons that in this case are most closely associated with classical liberal economists such as F. A. Hayek and Frederic Bastiat. As a result, CBA presents a useful foil when teaching about common pitfalls in economics, and it is a practical example of how antimarket ideas tend to become integrated into academic thought.

  2. Attributing Characteristics of Individuals to Society

    Cost and benefit estimates in CBA generally start out as measures of consumer and producer surplus. For example, when a project produces some beneficial outcome, analysts evaluate what individuals would be willing to pay for it, thereby generating an estimate of the project's benefits. Analysts then subtract the compliance or other costs associated with the project from this amount to assess the project's overall "net benefits."

    This procedure may make sense within a single period, but problems arise when making such evaluations across time. To compare surplus measures that accrue in different periods, benefit and cost estimates are entered into a utility function of the form

    [mathematical expression not reproducible] (1)

    where [beta] is a discount factor equal to [e.sup.-[rho]t], and [rho] is the rate at which the representative agent discounts future utility. The agent is often assumed to have isoelastic utility, such that U(c) = [c.sup.1-[theta]]/1-[theta] * [theta], the consumption elasticity of marginal utility, is typically assumed to correspond with the agent exhibiting diminishing marginal utility of consumption.

    From the outset, the choice of this utility function is strange because it is unclear exactly whose well-being it is meant to describe. The utility function is sometimes thought to describe the preferences of an infinitely lived representative agent or household (e.g., Liu 2003; Burgess 2013). Some economists are more straightforward in stating that it represents a social planner's preferences or, similarly, that it is a social welfare function that a central planner seeks to maximize (e.g., Dreze and Stern 1987; Nordhaus 2007; Arrow et al. 2014).

    Basing CBA on this social welfare function is strange because in other contexts, economists reject the notion that a single social welfare function can describe society's aggregated preferences. This rejection is a result of the influential work of Kenneth Arrow (1950), among others. Ironically, Arrow himself endorsed this social welfare function approach, (1) likely because he was willing to relax at least one of the restrictive axioms that his famous "impossibility theorem" depended upon: in this case, the restriction that no one is allowed to be a dictator whose preferences are always satisfied.

    The social welfare function that underlies CBA is an example of the tendency to ascribe characteristics of individuals to society as a whole. This attribution is directly contrary to an assumption central to Austrian economics, which is that only individuals act. CBA is inconsistent with this "methodological individualist" position because it takes the stance that society--or, alternatively, some mysterious social planner who seems to represent society or perhaps each subsequent generation (2)--has time preference and diminishing marginal utility like an individual.

  3. Discounting the Future

    Consumer and producer surplus estimates arguably have some meaning before they are entered into the utility function in equation 1. But once they have been transformed into units of the infinitely lived agent's utility through the practice of discounting, the meaning of benefit and cost estimates becomes unclear. F. A. Hayek famously warned that the word "social" "has acquired the power to empty the nouns it qualifies of their meaning." He referred to it as a "weasel word" (Hayek 1989). In CBA...

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