“Cost-benefit analysis” is a phrase nearly everyone has heard at some point in their lives. Even if it was as simple as getting advice when making a hard decision to write down all the pros and all the cons of making a decision, you have likely come across some sort of deployment of the concept of cost-benefit analysis in the past.
In the public policy world, “cost-benefit analysis” has a much more specific definition. Cost-benefit analysis is the systematic inventorying of the benefits and costs of a public policy and expression of these benefits and costs in monetary terms. There are widely-accepted textbooks on how to conduct cost-benefit analysis, executive orders governing how cost-benefit analysis is to be carried out on federal regulatory actions, and even an entire association of practitioners of the technique that holds a conference in Washington D.C. every spring.
Most scholars of cost-benefit analysis trace its theoretical roots to late 19th- and early 20th-century welfare economics. In particular, Arthur Pigou’s welfare economic framework laid the groundwork for cost-benefit analysis. In Pigou’s eyes, the economy can be understood as a system of preferences and preference fulfillment across a community. Transactions generate private costs and benefits and social costs and benefits. The sum of the benefits and costs across all transactions in a society comprises the totality of the economy.
The implication of Pigou’s understanding of the economy is that incentives can be realigned to grow the size of the economy. So if an economic activity has public benefits, it can be subsidized so the private benefits align with public benefits, increasing the activity and growing the economy. Public education is a great example of this. Without subsidy, public education will be underprovisioned. Subsidies bring private benefits in line with public benefits, growing the overall size of the economy. Similarly, activities that create public costs like pollution can be taxed to reduce their prevalence.
Cost-benefit analysis first made its appearance in U.S. federal policy around the turn of the century when large public water infrastructure programs were required to be subject to evaluation by the Army Corps of Engineers by the Rivers and Harbor Act of 1902. This approach was more of a fiscal accounting exercise rather than an economic analysis exercise at first, but by the 1950s, economists were bringing welfare economics into the practice, bringing public costs and benefits into the limelight.
The watershed moment for cost-benefit analysis in the United States occurred in 1981, when Ronald Reagan issued an executive order requiring regulatory impact analysis on major initiatives. Cost-benefit analysis became the standardized practice for major rulemaking throughout the federal government and agencies across the government started applying the practice to a range of different issue areas. His original executive order has been reaffirmed by six presidential administrations of different parties, including major revisions under George W. Bush and Joe Biden.
Okay, so that’s the history of the practice. But what actually is cost-benefit analysis?
Unfortunately, there is not a single, agreed-upon answer to this question. Some could say if a policy analysis follows what is in Boardman et al’s textbook on cost-benefit analysis that it qualifies. Others could use federal Circular A-4 as a guidance. The Society for Benefit-Cost Analysis has not adopted formal standards for cost-benefit analysis.
We have written a handbook on cost-benefit analysis that we have created as an approachable guide to the practice for analysts interested in conducting cost-benefit analysis at the state and local level. Within this handbook, we cover the eight elements of a cost-benefit analysis as laid out in a Pew Research Center study of the use of cost-benefit analysis in the states. The elements we identified are the following.
The study comprehensively measures direct costs. Direct costs of a policy, often measured as the government outlays required by a policy, should be included in any comprehensive cost-benefit analysis. This is usually what comes to mind when we talk about “costs” of a public policy.
The study comprehensively measures indirect costs. Outside of the direct costs, policies often have spillover costs associated with them. For instance, a recent cost-benefit analysis Scioto Analysis conducted on recreational marijuana legalization considered the productivity costs the economy would incur due to increased use of marijuana in a state.
Tangible benefits are monetized to the extent possible. A good cost-benefit analysis will not only quantify benefits, but will monetize them. This means trying to estimate how benefits translate into dollar figures that measure the strength of preferences people impacted by the policy have for benefits and costs associated with the policy.
Intangible benefits are monetized to the extent possible. While tangible benefits such as financial savings, increased revenue, or time savings should be monetized, a cost-benefit analysis should also include monetization of intangible benefits, like quality of life, environmental preservation, and knowledge and learning.
Program costs and benefits are measured against alternatives or a baseline. Cost-benefit analysis is ultimately a specific form of policy analysis. This means that a cost-benefit analysis should measure itself against another alternative. A standard alternative to measure against is “status quo,” or what would happen if the policy were not put in place.
Future costs and benefits are discounted to current year values (net present value). A dollar today is not worth the same as a dollar a year from now. Because of the investment value of that dollar and the uncertainties of the future, a dollar today is worth more than a dollar a year from now. A good cost-benefit analysis discounts future impacts to account for this.
Key assumptions used in calculations are disclosed. Assumptions in analysis are inevitable. A good cost-benefit analysis makes as many of these assumptions as clear as possible.
Sensitivity analysis is conducted to test how the results would vary if key assumptions were changed. Sensitivity analysis is the best tool we have to deal with the contingencies of uncertainty in an analysis. A good cost-benefit analysis will subject its assumptions to sensitivity analysis and a great cost-benefit analysis will conduct a simulation like a Monte Carlo simulation to test many of its assumptions in tandem.
This definition may change over time, but as far as I am concerned, this is the best definition of “cost-benefit analysis” I have found to date. If this sort of analysis were used in more public decisions, policymakers would come to those decisions armed with much more information than they currently do. And with that information, they will be better prepared to make the difficult decisions that constitute public policy.