Cost-Benefit Analysis

Introduction

Cost-benefit analysis and benefit-cost analysis refer to the same thing--weighing the pros and cons so you can make a decision.

Many costs and benefits are not obvious the first time you think about a question. Economists describe those costs and benefits as "hidden." For example, if you make an agreement with your roommate that you will do the cooking and he'll wash the dishes, you both may have forgotten initially that some of the meals you both like to eat entail way more dirty pots and pans than either of you realized. There was a hidden cost involved. Practicing thinking like an economist will help you anticipate a lot of potential hidden costs and benefits.

A particular kind of hidden cost is what economists call an "unintended consequence." Unintended consequences--after-the-fact fallouts, byproducts, or repercussions after embarking on a course of action that was based on a careful initial study of costs and benefits--often involve an unanticipated change in incentives. For example, if you live in a town where there is almost no undeveloped land left, you may be in favor of a new law allowing the town to buy up all the remaining farmland to use for town parks. You probably understand that there will be some extra taxes to buy the land and to maintain the land as parkland so it doesn't devolve into weeded, unusable overgrowth. You may even understand that the town is sacrificing the collection of higher tax revenues it might have gotten had the land been sold to other homeowners or businesses. But did you also think about the possibility that private citizens and companies in the town, now more stressed than ever for land, may now have an incentive to build taller houses and office buildings, or may expand their existing houses on the land they own to the boundaries of their property because they can't buy and move to larger plots and still stay in the town, say, as they have a second child and want a bigger house but want to stay in the same school district? Economists describe this as an unintended consequence. Not everyone is affected alike, even when the best of intentions are initially involved.

Economists absolutely recognize that not all benefits or costs can be measured monetarily. The financial pros and cons are typically only a portion of what matters when making a decision. Economists enjoy pointing out both what can't be measured with money and also finding clever ways to measure or estimate the monetary value of what can contribute to understanding the costs and benefits of a decision. You might as well tot up the monetary pros and cons as well as possible so that you can have that one piece of the puzzle nailed down.

The promoter of an idea typically plays up the benefits and plays down the costs. Economists delight in uncovering those hidden costs and often enjoy a moment of fun by taking the promoter by surprise. If, via your study of economics, you get better at pointing out hidden costs and unintended consequences, you may find that in addition to improving your confidence and understanding, you can win a lot of debates and bar bets!

Definitions and Basics

Benefit-Cost Analysis, from the Concise Encyclopedia of Economics

Whenever people decide whether the advantages of a particular action are likely to outweigh its drawbacks, they engage in a form of benefit-cost analysis....

Unintended Consequences, from the Concise Encyclopedia of Economics

The law of unintended consequences, often cited but rarely defined, is that actions of people--and especially of government--always have effects that are unanticipated or unintended. Economists and other social scientists have heeded its power for centuries; for just as long, politicians and popular opinion have largely ignored it....

Unintended Consequences, a LearnLiberty video.

Prof. Don Boudreaux explains what economists mean when they talk about unintended consequences.

Hidden costs and benefits. "What is Seen and What is Not Seen, by Frédéric Bastiat (pronounced bas-tee-AH). From Selected Essays on Political Economy.

In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen....

What if a change benefits some people but simultaneously harms others? John R. Hicks, biography from the Concise Encyclopedia of Economics

Hicks's fourth contribution was the idea of the compensation test. Before his test economists were hesitant to say that one particular outcome was preferable to another. The reason was that even a policy that benefited millions of people could hurt some people. Free trade in cars, for example, helps millions of American consumers at the expense of thousands of American workers and owners of stock in U.S. auto companies. How did an economist judge whether the help to some outweighed the hurt to others?...

In the News and Examples

Costs and Benefits of going to the dentist: The Marginal Tooth, by Bryan Caplan on EconLog

Every patient gets the same lecture: "If you don't floss, you'll loose your teeth. I told you this last time, and you're still not flossing!" Has it ever occurred to dentists that the marginal benefit of flossing may be less than its marginal cost?...

Costs and Benefits of preventing crime: Crime, from the Concise Encyclopedia of Economics

Economists approach the analysis of crime with one simple assumption—that criminals are rational people. A mugger is a mugger for the same reason I am an economist—because it is the most attractive alternative available to him. The decision to commit a crime, like any other economic decision, can be analyzed as a choice among alternative combinations of costs and benefits....

Costs and Benefits of recycling: Recycling, from the Concise Encyclopedia of Economics

Recycling is the process of converting waste products into reusable materials. Recycling differs from reuse, which simply means using a product again. According to the Environmental Protection Agency (EPA), about 30 percent of U.S. solid waste (i.e., the waste that is normally handled through residential and commercial garbage-collection systems) is recycled. About 15 percent is incinerated and about 55 percent goes into landfills.

Recycling is appealing because it seems to offer a way to simultaneously reduce the amount of waste disposed in landfills and to save natural resources....

Endangered species and the costs and benefits of saving lives: "Economic Value, the Value of Economists, and the Meaning of Life" by Don Coursey

To many, conclusions about species value seem at odds with the basic instinct that all life is worth saving. This is what makes public policy involving economic valuation of life so difficult....

Costs and benefits of believing: "The Economics of "Believe-It-Or-Not"" by Don Cox

To believe or not to believe? Economics provides a simple, almost trivial sounding, answer: believe something when the benefits of believing outweigh the costs, otherwise don't. Notice how a high-minded verb--"to believe"--starts to wither under the glare of economic analysis; the mundane science of choice seems to render everything to a widget-like state....

Does breaking a window help the economy by creating jobs for glass-repairers? "What is Seen and What is Not Seen", Frédéric Bastiat (pronounced bas-tee-AH).

Have you ever been witness to the fury of that solid citizen, James Goodfellow, when his incorrigible son has happened to break a pane of glass? If you have been present at this spectacle, certainly you must also have observed that the onlookers, even if there are as many as thirty of them, seem with one accord to offer the unfortunate owner the selfsame consolation: "It's an ill wind that blows nobody some good. Such accidents keep industry going. Everybody has to make a living. What would become of the glaziers if no one ever broke a window?..."

A Little History

However hard it is to total up the costs and benefits (or pros and cons) to make individual decisions like "Should I rent this apartment?" or "Should I spend a year abroad?", it's even harder when groups are involved. Should one person decide for the group? Should it be decided by 50-50 vote, or representation? Individuals do pretty well weighing the costs and benefits for close groups, like our families, by proxy—our parents, brothers and sisters, children, and spouses. But each extension to a wider group gets harder to justify. How should the desires be balanced when considering broad groups of people with different goals and opportunities—from extended family, to high school friends, to college communities, to towns, cities, religious groups, cultural affiliations—or a whole nation or cross-national cultural group? How can we decide when there is disagreement or conflict? See the biography of Nobel Prize winner Paul Samuelson for aggregating utility functions and revealed preference.

[Samuelson] introduced the concept of "revealed preference" in a 1938 article. His goal was to be able to tell by observing a consumer's choices whether he or she was better off after a change in prices, and indeed, Samuelson determined the circumstances under which one could tell. The consumer revealed by choices his or her preferences--hence the term "revealed preferences."

Costs are often calculated in relative terms by comparing how much work is involved. From Book I, Chapter 6, Of the Component Parts of the Price of Commodities, by Adam Smith in An Inquiry into the Nature and Causes of the Wealth of Nations

In that early and rude state of society which precedes both the accumulation of stock and the appropriation of land, the proportion between the quantities of labour necessary for acquiring different objects seems to be the only circumstance which can afford any rule for exchanging them for one another. If among a nation of hunters, for example, it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer. It is natural that what is usually the produce of two days or two hours labour, should be worth double of what is usually the produce of one day's or one hour's labour.

Advanced Resources

From Chapter 1. Cost in Economic Theory, by James Buchanan in Cost and Choice

Costs are calculated in units of resource input. "It usually costs" means that a specific resource outlay is required, an outlay that can be estimated in advance with some accuracy and measured ex post either by the resource owner or by an external observer who doubles as cost accountant. The relative costs of producing are objectively quantifiable, and no valuation process is necessary. Given a standard for measurement, relative costs can be computed like the relative weights of apples or potatoes. In Smith's elementary and conjectural model, the standard for measurement is a unit of homogeneous labor time. There are no nonlabor inputs (no other "negative goods"). The production functions for both deer and beaver are linear and homogeneous; that is to say, deer and beaver are available in unlimited supply at prevailing relative cost ratios. [par. 6.1.2]

From Chapter 1. Introduction, by James Buchanan and Gordon Tullock in The Calculus of Consent

The attainment of consent is a costly process, however, and a recognition of this simple fact points directly toward an "economic" theory of constitutions. The individual will find it advantageous to agree in advance to certain rules (which he knows may work occasionally to his own disadvantage) when the benefits are expected to exceed the costs. The "economic" theory that may be constructed out of an analysis of individual choice provides an explanation for the emergence of a political constitution from the discussion process conducted by free individuals attempting to formulate generally acceptable rules in their own long-term interest. It is to be emphasized that, in this constitutional discussion, the prospective utility of the individual participant must be more broadly conceived than in the collective-choice process that takes place within defined rules. [par. 3.1.12]

Related Topics

Margins and Thinking at the Margin
Opportunity Cost
Scarcity
Incentives
Government Failures, Rent Seeking, and Public Choice