© 2000 John Petroff
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© 2000 John Petroff |
A cost-benefit analysis is a ratio of costs divided by benefits.
The traditional cost-benefit analysis which does not involve discounting,
used to be the most common method in capital budgeting. A modern
version where costs and benefits are discounted, is exactly the
inverse of profitability index. Nowadays, traditional cost-benefit
analysis is still used in cases where the discount rate that ought
to be used, is very close to zero. For instance, when it is not
possible to determine a discount rate or when future benefits
are so uncertain that discounting would be a needless complication.
The method is most popular in public
finance because of a combination of the following reasons:
a- real rates of return on government securities approach zero;
b- with short term spikes in inflation, real rates of return on
government securities can turn negative, which clearly would not
be reasonable for a discount rate;
c- many financial decision in public works have political and
social dimensions that are more important than monetary ones.
Take for instance, the case of building a highway. The benefits are lower traveling time, additional economic activity in the region, and fewer road accidents. The first is easy to measure. The second is still not too hard to estimate. Whereas the third is very difficult to forecast, but saving lives is clearly more important than additional economic activity in the region or cutting traveling time. On the cost side, construction costs may be smaller than the cost of relocation and possibly retraining inhabitants whose houses must be demolished. In addition, the displaced households make up a political vote that may be damaging to government official making the decision. That is why looking at many alternative highway locations is imperative. A cost-benefit analysis is quite sufficient for such purpose.
See review questions Q-3G6.1 through Q-3G6.3.
See research assignment R-3.20.
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