Cost-Benefit Analysis

Theory and Practice

Efficiency is a key notion for welfare economics. Efficiency can mean either Pareto efficiency or Kaldor-Hicks efficiency. A governmental project (meaning any kind of governmental choice, such as a regulation, a public works project, or a spending program) is Pareto efficient, relative to the status quo, if at least one person is made better off by the choice and no person is made worse off. Virtually no one disputes that a Pareto-efficient project is normatively attractive. Nevertheless, in practice, very few governmental projects are Pareto efficient.

The construct of Kaldor-Hicks efficiency, developed by welfare economists during the 1930s and 1940s, purports to guide choice when the criterion of Pareto efficiency is inapplicable. A project is Kaldor-Hicks efficient, relative to the status quo, if the “winners” (those whose well-being is improved) could hypothetically compensate the “losers,” leaving at least some better off and no one worse off. Here, by contrast with Pareto efficiency, there has been much controversy. This focuses on the hypothetical nature of the Kaldor-Hicks criterion: it is not obvious why a choice that makes some persons worse off is normatively attractive merely because these individuals, hypothetically, could be compensated for their losses.

Welfare economists originally developed CBA as a tool for implementing Kaldor-Hicks efficiency. CBA measures welfare effects on a money scale, using the device of “willingness to pay” (WTP) or “willingness to accept” (WTA). Imagine that person P1 would benefit from a governmental project, relative to the status quo, and that P2 would be made worse off. The effect on P1 can be monetized by determining her WTP: with the amount of money deducted from P1's resources along with the implementation of the project, she would be neither better off nor worse off than in the status quo. The effect on P2 can be monetized by determining his WTA: with the amount of money added to P2's resources along with the implementation of the project, he would be neither better off nor worse off than in the status quo. A project is evaluated by aggregating its benefits (the total WTP of those who benefit) and subtracting its costs (the total WTA of those who are harmed). Projects are ranked in the order of their net benefits: a project with net benefits, relative to the status quo, is better than the status quo; and between two projects, the one with greater net benefits is better.

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