Skip Navigation Planning & Markets
Subscribe Submission Requirements Editorial Board Archive Links Search Home

IV. Cost Benefit Analysis (CBA) And Local Democratic Planning

There is no alternative to CBA as a comprehensive method of incorporating environment values and other external factors in a single decision criterion. Social prices are essential because of the failure of the market to reveal appropriate prices for environmental costs and benefits. Distortions in market prices are due first to government intervention through taxes, subsidies, and regulations. For example the price of rice in Japan is six times the world price due to government intervention. Second, external factors, which affect both costs and benefits, are not reflected in market prices. This is often due to failure, by design or default, of government to allocate and/or enforce property rights.

TABLE 3: The Benefits Transfer Method: Study Selection Criteria

Criteria for Selection Advantage Disadvantage
Environmental impacts similar in magnitude and type More credible for transfer of physical impacts because values associated with large changes may not be applicable to smaller ones May be difficult for non-scientists to find truly similar physical impacts
Primary study incorporates socioeconomic characteristics of the population Easily allows for adjustments to be made from primary study site to populations affected by the project being appraised May rule out the use of otherwise very good studies when the authors merely failed to report these characteristics
Regions similar in population size and composition, geography, and environmental characteristics Impacts and people affected may be similar, allowing for easier adjustment Assumes that the primary determinants of value are these similarities, when they may or may not be significant factors
High quality, up-to-date studies Most defensible for transfer of economic values, recent studies most likely to incorporate current economic conditions; may use state-of-the-art techniques May be too specific and narrow in focus to be of use and difficult to understand

Up-to-date studies may be difficult to obtain because such studies may not yet be published

There are two further problems: the distribution of income within nation states at any point in time, and the distribution of income over time and between generations. The first has been approached in principle and in static economic analysis by attributing different weights to benefits according to which income group receives them in a cost-benefit analysis (CBA). A particular problem arises with environmental issues where the poor may need to deplete the environment to survive. Rich people or nations can afford to conserve their own environment, but are less willing to pay poor countries to conserve theirs.

The distribution of income over time is dealt with by using an appropriate discount rate, although economists still disagree whether it should be large or small. And philosophers often differ from economists, who differ from each other about the proper discount/interest rate, especially where environmental and intergenerational factors are involved. The use of a lower discount rate in the public sector than in the private sector goes back to Pigou (1932) and his antecedents. Assumptions of market failure and normative redistribution of income are the core of welfare economics.

Welfare economic principles are applied in practice as CBA, and were first set out in comprehensive detail in a manual produced over four decades ago by Chenery for UNCLA (Chenery, 1958), but curiously not referenced in the many subsequent textbooks on the subject. This manual described in accounting detail how to calculate "shadow prices," or prices that would obtain if there was no market failure. Many subsequent books have elaborated the methodology and in the 1970s the World Bank produced for each country computer prints of shadow prices to be used in CBA of World Bank

And MDB projects. Every Bank project was in principle subjected to a CBA, which produced a social economic rate of return (EIR), or the true return in a project as if there were no market failure, using estimated social prices rather than distorted prices.

However, only the WB, the other MDB s and some other UN bodies have attempted CBA, which demands social prices, as a routine exercise. It has been used very occasionally in the UK or elsewhere. There are many reasons for the failure of CBA to catch on in rich countries, and its recent demise even in the relatively resource rich MDBs. But welfare economics in general, and CBA in particular, have found a new lease on life in environmental accounting.

First is the problem of estimating appropriate shadow or social prices. Some institutions and manuals, such as the WB's, advocate use of international prices (Little and Mirrlees 1974), while others, such as the UN, favor domestic prices (Mishan, 1971). And some economic theorists thought it did not matter provided the correct shadow exchange rate was used. This was very confusing for potential users of CBA in practice. For the most recent elucidation, see the ADB Manual (1997, pp. 15-34) and assess the general feasibility of the process in practice!

Second, rather than take extensive market failure for granted, as an inescapable factor in project appraisal, the WB has attempted through structural adjustment programs and cost recovery, in irrigation schemes, for example, to bring institutional prices closer to shadow prices. So, emphasis in a period of inescapable global financial constraint on public spending is more on financial rather than social accounting. Equally, environment and pollution externalities may be internalized sometimes by allocating and enforcing property rights where transaction costs are not prohibitive.

Third, the problem of appropriate discount rate has never really been solved and is usually provided exogenously and arbitrarily for public project analysis by the World Bank or by national governments. In the U.S., it is statutorily determined for the Water Authorities.

Fourth, the problem of income distribution is at the center of current debate on poverty and economic growth in both rich and poor countries. Trickle down is returning as a real alternative to welfare or investment programs financed by taxation but which may reduce global competitiveness and inhibit growth. Recent WB (2000) research on poverty indicates that the bottom 20 percent benefit pro rata from economic growth, and that governments are unable to target the truly poor with redistribution programs (McFarquhar, 1996). In practice it is almost impossible to find a CBA in which different weights are attached to benefits according to income level of beneficiaries, although this is advocated by theorists. It is also becoming clearer that if projects are used to redistribute income by an arbitrary (and probably unmonitored) amount, then market signals become confused. A subsidy to sustain a loss making industry may never lead to efficiency.

Fifth, CBA in general, and social/shadow prices in particular, will not stand up in courts, because courts do not tolerate hypotheses. Judges in both the U.S. and the UK have great difficulty with valuation involving simple concepts such as discounting and inflation. The concept of shadow/social prices is nearly impossible to explain. So CBA based on hypothetical costs and benefits may never be acceptable in law except in the U.S.. Most projects, especially those with environmental impact, are subjected in rich countries to planning courts that hear objections in a legal context, and apply a roughly democratic process in the context of political voting (Pearce and Nash, 1981).

Lastly, and perhaps most important, CBA in general, and social pricing in particular, take on an Alice-in-Wonderland quality in the view of its critics. Figures become what one wants them to mean. Projects are chosen first and figures manipulated to support the decision. Even the most conscientious project analyst can be sent back to the desk to reconsider his estimate of shadow prices until he hits upon the right set to fit a predetermined political decision. See Payer (1982).

CBA has been used for project selection in states and multinationals involved in a top-down, state driven investment processes. But in countries where the planning process is more bottom-up, and considers local objections or wishes of indigenous people, CBA is irrelevant as it measures net benefit to the state as a whole. Moreover it is an extremely costly procedure, requiring much professional skill. It reinforces market failure by assuming that efficiencies can be simulated without the signals of undistorted market prices. It distracts attention from the major causes of market failure, namely government price intervention, regulation, and failure to allocate and enforce property rights. No two CBA appraisers would produce the same result in a blind test. The procedure depends on "the Myth of Social Cost" (Cheung, 1974). By aggregating all environmental and external effects in a single cost or benefit stream, it is difficult to assess risk and uncertainty effects in the component parts in a political decision context.

This experience is relevant for environmental economists, who seem to be repeating past mistakes. Environmental economics is simply welfare economics reincarnate with the same estimation procedures and the same problems in practice: difficulty with estimating physical input-output relationships, debate about discount rate, political problems of appropriate norms as regards income distribution, difficulty of simulating market prices for environmental commodities and the implausibility of figures potentially driven by ideology. But estimation is difficult, not worthless, a point pursued below.

Given that both economists and non-economists load heavy criticisms on CV and CBA, why resuscitate these techniques, and why is use of CV becoming more popular in spite of past practical experience? Part of the answer lies in how multilateral and national administrations approach project appraisal. They search for an economic answer properly to inform an institutional political decision. No committee wants to be faced with a choice between incommensurables, a restricted CBA on one hand and a EIA on the other, so an environmental value has to be incorporated in the CBA, regardless of how casual or mongrel the estimated values may be. Of course obtaining even useless CV data is very costly, and project assessments have budgets and deadlines, so inevitably corners are cut. The recent advocacy of BTM where environmental values are derived from other countries or continents is an example, and may discredit CV even among the few who support it. The most recent manual on environmental valuation in ADB does not refer to shadow prices, which shows some uncertainty about incorporating environmental values in CBA, although the stated policy is so to do.

Consider the nature of the decision process. Pearce, et al (1989, p. 53), report that money is simply a convenient measure to inform the political decision process. This seems disingenuous (Lowe, et al, 1993, p.109), since measures are neither socially or politically neutral, nor is their use in a planning decision transparent.

Money implies consumer choice, not citizen choice (see above); and the privilege of existing property rights. Social choices, a potential source of political conflict have been anticipated (Lowe, et al, 1993, p. 110) and shifted into a technical box. This enables political disputes to be relegated into disputes between experts "The genius of cost benefit analysis is to localize conflict among affected individuals and thereby to prevent it from breaking out into the public realm," (Sagoff, 1988b, p. 97). Clearly on a roll, Lowe, et al (1993), continue "one of the shrewdest political moves in the book is to get your problem labeled "technical." "That simultaneously gets rid of any contending versions of the problem and depoliticises yours!" (Schwarz and Thompson, 1990, p. 139). Policy decisions involve a struggle between competing parties and the role of technique is "to find or make a reason for what one has a mind to do," (Lowe, et al, 1993, p. 110) and "decision makers undertake formal decision analyses with their minds already made up," and "the formal analysis is a kind of window dressing,"(Keney and Raiffa, 1976, p.9).

This is similar to how EIA, albeit eschewing economic valuation, is used to support a case for development (Bisset and Tomlinson 1988; Lee and Colley, 1990). This view relates to the use of CBA in multinational organizations where, once a project is selected for assessment, it is very seldom rejected, although CBA may be used to restructure a project into a profitable form. Indeed use of CBA in multinationals has been criticized for decades as ex post justification for projects that will go ahead anyway (Payer, 1982). Of course CBA is such that no two people presented with the same data for appraisal are likely to get the same answer; nor, indeed, the same person looking at the same data on different occasions. The possible exception may be where multinationals prescribe a set of the shadow prices that are used for projects in each country - as they used to do. This partly defeats the object of the process as prices may differ over time and have to be interpreted spatially and adjusted locally.

However the need to have a number to facilitate political and administrative decisions seems to be leading to rapid proliferation of environmental valuation (Sagoff, 1988 b). It is hard to find examples of CBA involving use of shadow prices in the West except, at one time, in the U.S., where it is legally prescribed in some sectors of environmental concern. Given the difficulties with complex criteria, it may be better to concentrate on environmental impact analysis (EIA). This can be compared with the economic return on projects that exclude valuation of the physical environmental factors involved. A decision is then made by trading off implicitly, in a political and democratic planning context, the economic value of the project against the losses incurred by the environment.

In a democracy this would be done in the context of political voting where lobbies or those with local or minority interests or indigenous peoples can express views in public through some sort of appeal procedure in the courts. This is a powerful procedure because each individual makes his own implicit judgement about the relative weights to be attached to each environmental factor, and the overall trade-off between environmental loss and economic gain. Problems of income distribution are partly solved by political voting because each person eventually has one vote in the democratic sanction of the decision-maker. Of course, rich minority lobbies have more power to publicize views, but the poor also protest effectively, at least in rich countries, by obstructing development projects.

By providing one comprehensive criterion to reflect a dubious aggregate, a national welfare function, CBA presumes to replace rather than inform the political democratic planning process. A more transparent form of governance would involve public choice theory, which attempts to assess which groups benefit and which lose in a planned development. This puts more emphasis on property rights of indigenous people, and on the importance of local consent in development driven by the state. Public choice theory fits more naturally into the democratic process. CBA emphasizes the benefit of the state at the expense of local people where a project is situated. Before consigning CBA to the dustbin of experience, it may be useful to review the more recent debate on valuation in general in Section V.

page 17


USC Seal

Main Page | Subscribe | Submission Requirements | Editorial Board | Archive | Links

ISSN 1548-6036

Copyright 1999-2000
University of Southern California
Los Angeles, California 90089-0626