Decision Making and Cost-Benefit Analysis
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….
ALL decisions involve costs. Indeed, there ain’t no such thing as a free lunch… What is TANSTAAFL?, at Marginal Revolution University.
What if a change benefits some people at the expense of 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
Thinking about costs when making decisions in life… Costs, Cancer, and Making Better Choices, by Steven Horwitz at Econlib. January 7, 2019.
Applying the economist’s concept of cost can also be incredibly useful for much of our everyday thinking. A sound understanding of the interrelated ideas of opportunity cost, marginal cost, and sunk costs can provide important guidance in navigating almost any situation of choice. Even those that we don’t think of as economic.
Using benefit-cost analysis to assess policy proposals to combat global warming: Global Warming, Cost-Benefit Analysis, and the End of Doom, by Bryan Caplan on EconLog (2016)
Cost-benefit analysis is imperfect, but so is every performance measure. We learn a lot more about policy effectiveness if we carefully measure costs and benefits, then reflect on potentially serious flaws, than if we refuse to play the cost-benefit game.
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….
More on recycling: Think Globally, Act Irrationally: Recycling, by Michael Munger
“The claims for recycling rest on an assumed, if not always articulated, moral imperative rather than on trade-offs or costs. But underlying this claim, for many people at least, is some murky idea that recycling ‘uses up’ fewer resources than making things from scratch.”
Hidden Costs. 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.
See: “What is Seen and What is Not Seen“, Frédéric Bastiat (pronounced bas-tee-AH). Famous essay about what economists do, emphasizing their role in pointing out the unseen, unspoken costs behind great-sounding ideas. Examples include national security, the arts, taxes, infrastructure, international trade, jobs, credit, business, and private decisions. Also available: Audio, condensed version, at CommonSenseEconomics.com
Hidden costs and economists’ goals defined, plus an example: Does breaking a window help the economy by creating jobs for glass-repairers?
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.”
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]