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THE BASICS OF BENEFIT-COST ANALYSIS

It is best to think of benefit-cost analysis in three steps. For a given course of action,

the method (1) identifies all impacts (pro and con) on all affected members of

society; (2) values these various benefits and costs in dollar terms;and (3) recom-

mends undertaking the program if and only if doing so produces a positive total

netbenefit to society—that is, if and only if total benefits exceed total costs.

Applying the Net Benefit Rule

According to the third step in benefit-cost analysis, the decision of whether to

undertake a given program hinges on the project’s net benefit. The program

should be undertaken if and only if

Net benefit Total benefit  Total cost 0,

that is, only if total benefit exceeds total cost. (As we shall see, if benefits and

costs occur over time, we must calculate the present discounted value of each

using an appropriate rate of interest.)

We can extend this basic rule to the case of several mutually exclusive pub-

lic programs. For instance, suppose the Department of the Interior is consid-

ering building a dam along a major river in the Pacific Northwest. The dam can

be built in one of two locations, according to one of three designs. Thus, there

are six possible dam plans: seven alternatives, including the option of not build-

ing. Among these mutually exclusive alternatives, the one with themaximum net

benefit should be selected.(If all dam plans imply negative net benefits, not

building the dam delivers the highest net benefit, namely zero.)

A second variation on the basic rule is applicable to public investment deci-

sions involving resource constraints. Suppose that if the dam is built, it will gen-

erate 1.5 million acre-feet of water per year. This water can be employed in a

number of competing uses, including allocation to city residents, local indus-

try, or farmers, among other segments. From a benefit-cost point of view, the

water should be allocated in a way that maximizes total net benefit. A simple

rule for allocating the limited supply of water is to compute the net benefit per

acre-footof water in each use. For instance, suppose the city’s net benefit comes

to $100/acre-foot, industry’s to $120/acre-foot, and farmers’ to $60/acre-foot.

Then industry’s demand should be satisfied first, followed by the city’s demand,

and finally the farmers’ demand.

The objective of these benefit-cost rules is to promote economic efficiency.

While all would agree on the need to use resources wisely, the way benefit-cost

analysis carries out this goal has come under criticism. Two points in the debate

center on the use of dollar values in step 2 of benefit-cost analysis, and the value

judgmentconcerning efficiency versus equity implicit in step 3.

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