Cost-Benefit Analysis (CBA) (Economics)

An economic theory that maintains that rational individuals base their decisions on the comparison of costs and benefits. Beyond the realm of individual or private CBA, public decisions made by governments are classified as social CBA. Social CBA has implications for nonmarket participants and the use of scarce resources.

Externalities are generated when nonmarket participants incur part of the costs of market transactions and governments will have to decide whether to tax or subsidize a particular activity. Such a decision is normally evaluated on the basis of social cost versus social benefit. To encourage or discourage any activity, a planner must know the social value (shadow price) of the activity. If the market price is less than the social value, the scale of the activity should be expanded. CBA measures social value.

Since economic resources are scarce relative to societal wants, resources must be allocated in such a way that they are not overallocated or underallocated to an [Page 116]economic activity. This means that the marginal social cost must be equal to the marginal social benefit (the additional benefit must be equal to the additional cost).

Advanced econometric techniques, such as constrained optimization and linear programming, can be used to estimate incremental costs and benefits. For more information, see Brent (1997).