Decision Criteria and Decision Methods for Policy Analysis
3. DECISION METHODS
3.3 Benefit-Cost Analysis
Under a benefit-cost analysis criterion, economic efficiency becomes the guiding criteria or rule. The best policy should maximize net benefits to society – that is, provide the greatest net gain, without regard to who gains and who loses. After all, if the gains exceed the losses, then it is possible for the gainers to compensate the losers and, therefore, for everyone to be better off.
Under this criterion, it is clear that the marketable permit approaches dominate the standards approaches, since the benefits are the same for each ozone concentration but the costs are lower for the permits alternatives. Further, the 0.10 ozone concentration of Alternative B2 (permits) has net benefits over the status quo of $50 million, while the 0.08 concentration with permits has no net benefits over the status quo.
Therefore, the 0.10 ozone concentration with marketable permits is the preferred alternative. Another way to see that the 0.10 concentration is superior to the 0.08 concentration is that the additional (marginal) benefits of going to the lower concentration are $25 million, while the additional (marginal) costs are $75 million.
Note that here, economic efficiency is being used as a decision rule rather than a decision criterion. As a criterion, the net benefits of an alternative would be a factor in the decision, but they would not necessarily determine the preferred outcome. As a rule, on the other hand, the net benefits decide the outcome. In essence, a benefit-cost decision rule is a form of criteria ranking, where the primary criterion is economic efficiency.
The first advantage of a benefit-cost decision rule is that it ensures that the benefits do outweigh the costs for an activity (in comparison to the status quo – remember the with-and-without principle!). While having positive net benefits may seem like an obviously desirable thing, many public projects are undertaken that impose net costs on society. For instance, many government activities provide subsidies to specified producers; typically, these are economically inefficient. A benefit-cost decision rule would eliminate those programs that cost more than they are worth.
Secondly, as noted above, because this rule ensures that society gains from the activity, then it is possible for everyone to gain from the activity.
Even if some groups bear costs, the gains to the rest of society can be used to compensate them for the loss. For instance, in this example residents in general and agricultural producers benefit from the cleaner air, while utilities bear the cleanup costs. In this case, higher electricity rates from the consumers (and perhaps even higher rates for farms) might provide the additional funding needed for the utilities to pay for the cleanup. The higher rates, if less than the increased benefit from improved air quality, could make the utilities willing to pay for the abatement effort. In this case, everyone is at least as well off as before, and some gain, since there are net gains to be had.
These points also suggest several problems associated with a benefit- cost rule. First, and probably most important for environmental policy issues, all the benefits and costs of an action need to be incorporated into the analysis. Thus, in our example, it is important to include not only the market effects of ozone on agricultural crops, but also the (relatively) non- marketed effects on human health into the calculation. If ozone has other effects (as it does), such as reducing visibility and increasing corrosion of iron and other goods, then those need to be included in the calculations as well. Especially in the past, benefit-cost analysis often only covered those goods with easily measured market prices and quantities. Especially since the advent of the National Environmental Policy Act of 1970, economists have put a tremendous amount of effort into ensuring that environmental effects are included in benefit-cost analysis. These efforts are controversial – how much is an endangered species worth? Can a human life be measured in dollars? On the other hand, putting dollar values on these resources makes clear that these resources have real economic value, and that people are willing to pay to protect the environment. Not including them in a benefit-cost analysis biases the analysis toward environmentally destructive activities.
The second objection to benefit-cost analysis is that, even if it is possible to make everyone better off from an action, usually there are
winners and losers from a government action. In the above case, agricultural producers and people sensitive to air pollution gain from reduced ozone, but utilities and their customers bear the costs. Is it surprising that utilities might oppose the tighter ozone standards? Is it surprising that agricultural producers and pollution-sensitive people will lobby for the 0.08 ozone concentration even though it is less efficient than the 0.10 standard? While benefit-cost analysis might be a useful assessment of the effects of a policy on society, the distributional effects of the policy are likely to have much more explanatory power for how interest groups behave. As long as decisions are made by people who might be influenced by interest groups, benefit-cost analysis may end up as a decision criterion rather than as a decision rule.
Box 3-2. BCA at EPA
Eban Goodstein (1995) evaluated two benefit-cost analyses (BCAs) from the U.S. Environmental Protection Agency (EPA) to determine whether EPA conducts good BCAs and whether BCAs affect regulatory decisions.
One BCA considered three options of varying stringency to determine acceptable levels of lead leached from solder on pipes into drinking water.
EPA identified numerous health benefits from reduced lead exposure, but a high level of uncertainty limited EPA’s ability to quantify health benefits.
EPA failed to factor that uncertainty into the analysis and ignored benefits that could not be translated into dollars. Although EPA eliminated a clearly inefficient option, the uncertainty associated with benefits prevented EPA from distinguishing between two options with similar stringency. EPA ultimately selected the less expensive, and slightly less stringent, option.
The landfill BCA included 2 options for toxic leaching into groundwater:
a less stringent “pollute and cleanup” option, and a stricter prevention approach. The benefits of access to suitable drinking water were reduced cancer risk and avoiding costs of replacing damaged groundwater. The cancer risk estimates were low because of uncertainties with the extent of leaching over time and human exposure to hazardous waste, and because few people rely on groundwater wells within a mile of landfills. EPA assumed that reduction of groundwater effects were all the benefits and insufficiently weighed uncertainty in benefit and cost predictions. EPA further considered a tradeoff between equity and efficiency and chose an option that seemed to favor equity for citizens residing near landfills over efficiency. EPA justified the selection of the more stringent pollution prevention option with unquantified benefits and equity implications.
Goodstein’s analysis of these two BCAs led him to conclude that EPA overall conducts good benefit-cost analysis. EPA works to develop theoretically consistent benefit and cost measures, identifies and justifies assumptions, provides realistic upper and lower bounds for benefit and cost estimates, and includes background information. In neither case, though, did EPA choose the option that maximized net benefits, and Goodstein estimates the efficiency loss at $3 billion. On the other hand, the analyses may have enabled EPA to choose a more efficient option than would have been selected in the absence of the studies.
BCA does not offer significant benefits when EPA must address unquantifiable or intangible health benefits because it is difficult to identify efficient outcomes. Goodstein suggests that EPA consider devoting BCA resources to issues with large intangible and uncertain marginal benefits of regulation and to exploring alternative equity goals at lower costs.