The government uses cost-benefit analysis to decide whether to provide a particular public good and how much of it to provide. Cost-benefit analysis, which is also sometimes called benefit-cost analysis, is a systematic process for calculating the benefits and costs of a project to society as a whole.
The positive and negative effects captured by cost-benefit analysis may include effects on consumers, effects on non-consumers, externality effects, or other social benefits or costs. The guiding principle is to list all parties affected by a project and add a negative or positive value that they ascribe to the project's effect on their welfare. Benefits and costs are expressed in monetary terms, and are adjusted for the time value of money, so that all flows of benefits and costs over time are expressed on a common basis in terms of their net present value. Financial costs tend to be most thoroughly represented in cost-benefit analyses due to relatively abundant market data. It is much more difficult to capture non-financial welfare impacts. For example, it is very difficult to place a dollar value on human life, consumers' time, or environmental impact.
Imagine that the government is considering a project to widen a highway . The benefits side of the analysis might include time savings for passengers who can now avoid traffic, an increase in the number of passenger trips (as more people could now use the road), and lives saved by dint of fewer car accidents. The cost side of the analysis would include the cost of land that must be acquired prior to construction, construction, and maintenance. These costs and benefits will need to be translated into monetary terms for the sake of analysis.
The Highway as a Public Good
The benefits of a highway expansion project might include time savings for passengers, additional passenger trips, and saved lives. Costs might include construction and maintenance.
The procedure for conducting cost-benefit analysis is as follows:
- Identify project(s) to be analyzed.
- Estimate all costs and benefits to society associated with the project(s) over a relevant time horizon.
- Assign a monetary value to all costs and benefits.
- Calculate the net benefit of the project (total benefit minus total cost).
- Adjust for inflation and apply the discount rate to calculate present value of the project.
- Calculate the net present value for the project(s).
- Make recommendation about project(s). If the benefit outweighs the cost, then the government should proceed with the project.