CBA (Cost Benefit Analysis)

• Cost-Benefit Analysis (CBA)

  A decision-making tool accounting for the social cost and the social benefits of a project over time to establish its net present value
• Costs and benefits included in CBA

  • Private costs
  • External costs (negative externalities)
  • Private benefits
  • External benefits (positive externalities)
• Costs and benefits included in CBA can occur in the future, not just the present
• Net Present Value (NPV)

  The net value of all costs and benefits, accounting for the time value of money
• Projects that have undergone CBA

  • Crossrail
  • HS2
  • Olympic Games
• Purpose of CBA

  • To understand whether the allocation of resources is as efficient as possible
  • If NPV is positive, the project is worthwhile and an efficient allocation of resources
  • If NPV is negative, the project is inefficient and should not be pursued
• Steps in conducting CBA

  1. Identify private and external costs/benefits

  2. Make value judgments on which costs/benefits to include

  3. Attach monetary values to costs/benefits

  4. Apply weights and probabilities to costs/benefits

  5. Apply discount rate to future costs/benefits

  6. Calculate NPV

  7. Conduct sensitivity analysis
• Discount rate used in CBA

  Based on government bond yields, reflecting expectations of inflation
• Limitations of CBA

  • Difficulty in identifying all relevant costs and benefits
  • Difficulty in accurately assigning monetary values, especially to external costs/benefits
  • Subjectivity in assigning weights and probabilities
  • Potential bias if CBA is conducted by interested parties