Cost-Benefit Analysis

One criterion by which public policies are evaluated is the ability to maximize economic efficiency, or the net benefits to society. A policy that achieves this goal provides the greatest amount of benefits to society at the least cost. Therefore, the government, under this standard, should not pursue policies for which the costs to society exceed the benefits or for which the difference between costs and benefits may be increased by alternative policy measures. Cost-benefit analysis (CBA) is an analytical tool that can be used to support such decision making.

Opportunity costs, or the value of resources if allocated for their best alternative use, are used to measure the costs to society of pursuing a public policy proposal. This cost differs from the typical accounting costs associated with expenditures by businesses or government, which may not reveal the true costs to society. For example, the effects of regulation on such economic variables as productivity and unemployment are not captured in accounting costs but may still present costs to society. Opportunity costs may be measured by using data on market trends to determine the value of forgone goods and services.

Benefits to society may be divided into market benefits and nonmarket benefits. Many benefits associated with market interactions may be easily valued in dollar amounts according to the relative gains in the market that can be measured as a consequence of public policy. However, nonmarket benefits—those that cannot be directly valued in terms of dollars—require different methods in assessing their value. An example of nonmarket benefits are those that arise as a result of the preservation of a forest. A forest may have value that stems from use that is not paid for by the consumer, such as recreational activities. Value may also lie in the potential for the forest to provide future benefits that are unknown and that would be destroyed in the absence of the forest. Plant species that have the potential to provide future medical benefits, for example, may be destroyed without the protection of a forest. The existence of the forest also provides benefits to future generations. Whether someone uses or directly benefits from a forest, they may find value in knowing that the forest and its inhabitants may be enjoyed by others. Therefore, the total nonmarket value of a forest is the sum of the values associated with direct use, future options, and existence of the forest.

To quantify these values, analysts using the cost-benefit approach must determine society's willingness to pay for the preservation of the environment or society's willingness to [Page 87]accept recompense for environmental destruction. Analysts may observe this preference in a population through contingent valuation—surveys that measure stated preferences of the population. Travel costs, or the amount spent to use a resource, may also be used to measure nonmarket benefits. This is an indirect approach in which people reveal their preferences through their actions and behavior. Another approach that uses revealed preferences is called hedonic regression. This measure uses the change in prices of related goods to determine people's willingness to pay. For example, if the value of surrounding homes decreases as a result of environmental degradation, this market signal reveals the preference of local homeowners to protect the environment.

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