Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
Concept of Social Cost-Benefit Analysis
Every economy has limited resources at its disposal. The government of an economy should make the best use of those limited resources in order to maximise social welfare. In making the decision of how much of a public good to provide, the government uses social cost-benefit analysis, which is a fiscal instrument intended to improve the efficiency of public sector budgetary decisions. Resource scarcity would mean making choices among various project proposals or investment decisions.
Therefore, different alternatives need to be compared before making a choice. Cost-benefit analysis is an economic tool which provides a simple and practical assessment of various available options. It is the general methodology that has been developed to make expenditure decisions by the legislator or the executive.
Meaning of Social Cost-Benefit Analysis
Social Cost-Benefit Analysis refers to a systematic and formal method of evaluation of public expenditure. It takes a broader view of all benefits and costs than just considering financial profitability. It involves accounting exercises which compare the costs and benefits of public goods projects. It provides a consistent basis for assessing whether a project should be undertaken or, if there are many options, which project(s) should be undertaken.
A project is considered worthwhile if the net social benefit (defined as an excess of benefits over costs) of a project is positive or if the benefit-cost ratio is greater than one. As benefits and costs of large projects accrue over a number of years, the need is to summarize these streams of benefits and costs accruing over a number of years. For this purpose, discounting is used to estimate the present or discounted value of future benefits and costs.
The following formula shows the calculation of Net Social Benefit:
Project Evaluation
Explanation:
Project evaluation determines the ways to make the most efficient use of scarce resources. The basic issue involves the determination of the composition of the budget or allocation of total funds among alternative projects (Musgrave and Musgrave, 1976). The advanced issue involves the determination of the appropriate size of the budget.
In other words, there are various situations in which one needs to determine the size of the budget and, in others, the composition of the budget. It also depends upon whether projects under evaluation are divisible or lumpy in nature. To understand these situations, assume that benefits and costs are known. Now, depending upon the nature of the project (divisible versus lumpy) and budget (fixed versus variable), some decision rules have been developed which apply in the selection of projects.
We explain these situations in detail and the respective decision rules in each case in the following section.
Underlying Principles of Project Evaluation: Decision Rules
1. Divisible Projects and Fixed Budget Size:
If all public projects are finally divisible and may be changed by a small amount, then the best way to allocate a given sum between any number of expenditure projects would be based on equalizing the marginal benefits from the public projects, i.e. funds should be distributed among projects in such a way that marginal benefits from these projects are equal. This equalization of marginal benefits from various public projects maximizes the sum of total benefits derived from all the projects.
2. Divisible Projects and Variable Budget Size:
The government not only needs to decide the division of resources fixed for public use among various public projects but also needs to determine the division of resources between public and private use.
If the budget is fixed, the opportunity cost of pursuing one public project is defined by the benefit lost in terms of not pursuing another public project. In variable-size budgets, the opportunity cost of public projects is the benefit lost by forgone private projects.
In such a case, the best way to allocate resources is to maximize the net benefits (benefits minus costs) of both public and private projects. This can be achieved by expanding public projects and restricting private projects until the marginal benefit (benefit from the last dollar spent) in either sector is the same.
3. Lumpy Projects and Fixed Budget Size:
In situations when projects may not be increased or decreased by small amounts, it may not be possible to equate the benefit of the marginal dollar spent on each project.
The best way to allocate resources is to choose the project mix so as to maximize the net benefits subject to some qualifications, viz., left-over funds are worthless. For example
Table 1
| Project | Cost (C) | Benefits (B) | Net Benefits (B-C) | B/C | B/C Ranking |
| I | 200 | 400 | 200 | 2.0 | 2 |
| II | 145 | 175 | 30 | 1.2 | 5 |
| III | 80 | 104 | 24 | 1.3 | 4 |
| IV | 50 | 125 | 75 | 2.5 | 1 |
| V | 300 | 420 | 120 | 1.4 | 3 |
| VI | 305 | 330 | 25 | 1.1 | 6 |
| VII | 125 | 100 | – 25 | 0.8 | 7 |
Table 1 shows various projects (I-VII) and their respective costs and benefits. Supposing fixed budget size is $700,000. Experimenting with various combinations of the projects reflects that net benefits are maximized when projects IV, I, V and II are chosen; total cost is $695,000, benefits are $1,120,000, and net benefits are equal to $425,000. $50,000 remains unspent. If we consider this unspent amount as worthless, the above rule gives the best project mix in the current situation.
But generally, we find a setting in which projects are lumpy, and budgets are limited. In that case, another rule is more applicable, which requires minimizing the amount left over, subject to the constraint that the B-C ratio of projects is greater than 1.
4. Lumpy Projects and Variable Budget Size:
In a situation with no fixed-size budget, the best way to allocate resources is to choose all projects which yield positive net benefits. It is so because, in the case of lumpy projects, benefits from marginal outlays cannot be equalized. Therefore, it would be proper to undertake a public project so long as the benefits of the project exceed its costs.
Estimation of Costs
Meaning of Benefits:
Benefits, in a broad sense, include the extent to which objectives are attained. As Goode (1986) explains, benefits “may include increases in consumable output, improvements in the distribution of welfare among consumers, and gains in the capacity for national independence”.
The benefits of a project may be differentiated as real or pecuniary. As explained by Musgrave and Musgrave (1976), real benefits are the ones derived by the final consumers of the public project. Pecuniary benefits come about because of changes in relative prices, which occur as the economy adjusts itself to the provision of public service and the pattern of resource demand changes. In this case, the gains or losses of some individuals are offset by losses or gains experienced by others; as a result, pecuniary changes do not reflect net gains or losses to society. But real benefits and costs reflect an addition to the community’s welfare and reflect net gains or losses.
In cost-benefit analysis, generally, only the real benefits of a project are considered. Real benefits are classified as follows:
- Direct versus Indirect Or Primary versus Secondary
- Tangible versus Intangible
- Intermediate versus Final
- Inside versus Outside
Meaning of Costs:
Costs represent the forgone opportunities which are measured in terms of prices paid for inputs, consisting of capital costs and operating costs. This approach, as used by accountants, is known as the cash-flow accounting approach to measure the costs and benefits of a project. But to determine the optimal level of public goods, the concept of social marginal cost is used. The social marginal cost of a resource is measured in terms of the opportunity cost of that resource, i.e. the value of that resource in its next best use.
Examples of opportunities include:
- using land in a different, or more valuable, way than its current use
- the alternative use of an employee’s time and
- Investing in a public transport system instead of building additional roads.
In these examples, opportunity cost represents the next best alternative forgone in favour of the taken-up opportunity. Opportunity costs are reflected in market prices, for example, the market price of land. Thus, the social marginal cost of an input is determined by its market prices but by the next best use to which the input can be put by the society.
Types of Benefits and Costs: An Illustration
*The benefits and costs noted in the table are merely illustrative for each project and not intended to be comprehensive.
In the table, illustrative costs and benefits are presented for various projects such as irrigation, moon shot and education.
Estimation of Costs:
In conducting an analysis of various proposals, the first step is to identify all the relevant costs, and the next step is to assign monetary values to these costs. Sometimes, it is impossible to quantify a cost in monetary terms because of any or all of the following reasons:
- reliable measurement of a particular cost cannot be done,
- a particular cost is not significant to the analysis,
- The amount of effort or resources required to value a particular cost outweighs the merits of including it in the analysis.
Further, costs can be valued in real terms and nominal terms. Since real prices eliminate the impact of inflation and make comparisons more consistent, measurement is generally done in real prices. Further, market prices are normally used for estimating costs as their identification is easy. However, market prices do not account for various imperfections and distortions in the market, such as monopoly pricing, externalities, etc.
In some cases, the market really does not exist, and it is not possible to observe prices and estimate costs, for example, environmental and social costs. We call such things as intangibles. Their prices are not directly observable due to missing markets.
There are techniques to put a value on the costs/benefits of intangibles in the analysis. These are briefly explained below:
- Shadow prices are used in cases where the market price does not reflect the true cost of a good or service to society. For example, in the case of a subsidy for goods, the shadow price would be the market price marked up as a per-unit value of the subsidy.
- Revealed preference testing assigns a value to a good which is not traded directly in the market using the value of a related good being traded in the market. For example, differences in prices of identical houses (houses are identical in all respects except for the level of air pollution) may be used to assign a value to buyers’ willingness to pay for cleaner air.
- Stated preference testing estimates a consumer’s willingness to pay for a good or service or willingness to accept compensation for consuming a bad, such as pollution or tolerating a negative economic outcome, by conducting surveys in hypothetical markets.
Discounting and Discount Rate
Explanation:
One has to regard the fact that benefits and costs do not accrue only instantaneously but also over time. For example, one-time costs of a project have to be combined with a future stream of costs. Since cash flows from investments occur in the present as well as future points in time, the same weight cannot be given to the flows occurring in different periods.
The technique of discounting is used to assign weights to these streams of earnings occurring over a number of time periods. Generally, cash flows occurring sooner are given more weightage than flows occurring later. The discounting technique gives us the present value of all streams of cash flows. These present values of various projects can be effectively used for making a rational choice among projects.
Present discounted values for social investments are calculated using an appropriate rate called the social discount rate. In the case of investment decision-making by a private firm, an appropriate discount rate represents the opportunity costs of the funds in question. In the case of government, it is the private-sector opportunity cost, i.e. “the next best use of any money by the government is its use in the hands of the private sector” (Gruber, 2007).
The discount rate chosen should not include the effect of inflation. The following formula can be used to remove the effect of inflation from discount rates:
Formula: (1+nominal discount rate) ÷ (1+inflation rate) – 1
Rationale for Discounting
The first justification for discounting future flows is that, in general, a person would prefer to receive a rupee now rather than tomorrow.
Another justification is that while assessing a proposal, a person would desire a return from the proposal which is higher than a return from any other venture of equal risk. Discounting determines the net benefit or cost over and above the return from other ventures of equal risk; if Net Present Value (NPV: aggregate discounted net cash flows over the period) is greater than zero, it indicates the return is higher than in other proposals of equal risk and if it is negative then vice-versa, a value of zero indicates an equal return. In this way, several projects can be compared on the basis of NPV.
Formula for Discounting
Discounted value now = Future value in nth period x Discount factor (in period n)
= Future value in nth period x 1/(1+discount rate)n
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