Cost-Benefit Analysis

Cost-benefit analysis has been described as a "practical way of assessing the desirability of projects, where it is important to take a long view (in the sense of looking at repercussions in the future, as well as the nearer future) and a wide view (in the sense of allowing for side effects of many kinds on many persons, industries, regions, etc.) i.e. it implies the enumeration and evaluation of all the relevant costs and benefits" (Prest & Turvey 1965).

The development of cost-benefit analysis in the assessment of transport projects, in Britain, started in the late 1950s. Two early experimental studies were by Coburn, Beesley and Reynolds (1960) on the London-Birmingham Motorway and by Foster and Beesley (1963) on the Victoria line.

There are similarities between a private economic evaluation that might be made by a company before making a capital investment and a cost benefit analysis made by government before making a capital investment[1] . In both, estimates of the likely costs and benefits, how large they are, and when they will occur, are made. After discounting the future streams of costs and benefits to some measure such as their present value, a decision can be made as to how worthwhile the investment is. The important difference between a private economic evaluation and a cost-benefit analysis is that in the former only internal profit or loss is considered whereas in the latter all costs and benefits are considered, both internal and external. In cost-benefit analysis benefits are taken as the increase in consumers surplus which occur due to the change being considered.

In their survey of cost benefit analysis, Prest & Turvey (1965) list the main questions which have to be answered in an analysis as

Which costs and which benefits are to be included?
How are they to be valued?
At what interest rate are they to be discounted?
What are the relevant constraints?

Enumeration

Ideally all costs and benefits to whomsoever they accrue should be considered in the analysis. Once the costs and benefits have been identified, their physical size must be calculated.

Evaluation

Having enumerated what benefits and costs exist they must be evaluated. This requires the placing of a value on diverse physical, and sometimes non-physical, quantities. The generally accepted values to use are those determined by the market. It is assumed that people act in a rational manner and that the present situation is a close approximation to the equilibrium position, to which the market is always moving. At equilibrium all commodities demanded are produced, all factors of production are in use and the marginal utility of all consumption is equal. In this position no one can be made better off without someone else being made worse off, since production is at a maximum, so, to make someone better off some of the produce would have to be shifted from one person to another, so making someone else worse off.

Provided the conditions prevailing in the "market" approximate those in the "pure market", market determined prices will approximate the marginal social value of all commodities and their use is justified because the use of any other would require individual subjective value judgments.

Discounting

Once the costs and benefits have been enumerated and evaluated some process must be followed so that costs and benefits which accrue at different times in the future can be compared. The most widely used procedure is to discount the streams of costs and benefits to their present worth. To do this a time preference or discount rate must be chosen. It reflects the desirability of receiving a benefit this year rather than next year. Further consideration is given in Chapter 9 to the problems involved in the choice of a time preference rate.

Constraints

There will be several types of constraint which may have to be taken into account in an analysis. There may be physical limitations on the size of possible benefits. There may be legal and/or administrative limitations on the size of specific costs or benefits, and to whom they may or may not accrue. There may also be a limited budget, in which case any project which exceeds the budget will not be allowed, no matter how large its benefits may be.

Enumeration and evaluation of transport costs and benefits

In the cost-benefit analyses of transport projects, benefits have tended to be restricted to those accruing to transport users and operators. They have been regarded as the increase in consumer surplus produced by the change, that is the reduction in user and operator costs. More recently costs imposed on others have also been included.

User costs can be considered as the monetary costs of travel, time costs and accident risk. Operator costs for roads are those such as road maintenance, police, lighting and accidents. The other costs which are considered include noise, vibration, visual intrusion, etc. Any increases in these costs are usually considered as negative or dis-benefits.

Project Selection

When there are several projects competing for a limited allocation of funds cost-benefit analysis can be used to make the choice of those with which to proceed. Provided there are no mutually exclusive projects, those which have the highest ratio of discounted benefits to discounted costs should be implemented first.

[1] Just as the company might make an evaluation if it were going to change only its mode of operation, so cost-benefit analysis can be used in more cases than that of capital investment.