Lecture 1 - Introduction to CBA

Levan Pavlenishvili

ISET

2021

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Table of Contents

1 About the Course

2 Individual Vs. Social Cost-Benefit
3 Types of CBA
4 Basic Steps in CBA
5 Use of CBA - Bureaucratic and political lenses
6 The origins and demand for CBA
7 Cost of Doing CBA

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About the Course

The Cost-Benefit Analysis (CBA) is a course that intends to build

theoretical and practical understanding of using CBA methodology
in decision making.

CBA will make use of your knowledge in past courses such as

Microeconomics 2 and Econometrics 2.

CBA will show you how your knowledge in economics is applied in practice.

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About the Course

Assessment:

Group Project - 30%

5 Pop-up Quizzes - 10%
Mid-term Exam - 20%
Final Exam - 40%

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About the Course

Main Textbook:
[BGVW] Boardman, Anthony E., David H. Greenberg, Aidan R. Vining,
and David L. Weimer. Cost-Benefit Analysis: Concepts and Practice. 5th
ed., (Upper Saddle River, NJ: Pearson Education, 2018).

Other course materials, such as slides will be available on Moodle every

week.

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About the Course

Group Project:

Create groups of 4 students - September 22 - October 7;

Group projects will be published - October 7;
Topic of the project is the same for all groups, part of the input data
will be different;
Progress update meetings with all groups - Once in three weeks
(upon request);
Project Report - excel file and presentation slides;
Project Presentation - December 22 (tentative)

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About the Course

Office Hours:

Office hours will be every Monday at 13:00 p.m. upon request no

later then every Friday 6:00 p.m.;
Zoom link will be shared for Tuesday’s Office hours if there was a
request on Monday. Otherwise, there will be no office hour for
specific week.

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Individual Vs. Social Cost-Benefit

(Reading - [BGVW] pp. 1-27 )

The cost-benefit analysis is a systemic cataloguing of costs (cons) and

benefits (pros) of the action, by valuing and monetising impacts in order
to determine net benefit:

NB = B − C
where, B represents benefits, C represents costs;

Basic Principle of CBA

If NB > 0 - you are good to go to take an action!!!;
If NB < 0 - you should reconsider.

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Individual Vs. Social Cost-Benefit

In conducting financial analysis we tend to consider our own costs and

benefits i.e. ones that accrue to us.

In CBA we consider social costs and benefits, meaning we have to

consider all impacts that accrue to different groups of society. Thus, our
models should represent circular character of economic activities.

Remember: In economy, one person’s benefit could be other persons

cost, or the other way around. However, due to ’growth effects’ everyone
might also benefit.

The purpose of CBA is to help decision making in a society, to identify

values of costs and benefits and analyse their allocation.

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Individual Vs. Social Cost-Benefit

Identification and valuation of ’social’ costs and benefits requires having a

certain ’benchmark’, or counterfactual.

This normally means having a certain ’status quo’, or business as usual

policy, compared to which costs and benefits are identified.

It is vital to understand clearly what counterfactual is (having clear

assumptions), otherwise in setting of an economy you will have to model
all conditions in the economy, which is impossible.

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Individual Vs. Social Cost-Benefit

Criticism

Philosophy - Some economists and philosophers criticise CBA approach

due to fundamental utilitarian assumption of trying to maximise individual
utilities, or monetising some impacts such as value of life.

Practical - Many practitioners of CBA frequently disagree about particular

methods used, impacts accrued, or trade-offs between present and future.

P.S. Some practitioners might disagree about ways to cheat, after all:

”All models are wrong, some are useful” - George Box

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Types of CBA Analysis

There are three main types of CBA analysis based on the time, when it is
conducted.

1 Ex ante CBA - is conducted before action is taken and helps

decision-making process. Answers the question: Is it a good idea to
implement the policy / project?
2 Ex post CBA - is conducted after action is taken and intends to
analyse if taking the action was a good idea?
3 In medias res CBA - is conducted during the policy / project
implementation period to analyse implementation process and update
ex ante analyses.
CBA could also be quantitative (involving mathematical model) and
qualitative (suggesting potential pros and cons of the policy / project)

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The Basic Steps of CBA

1 Explain the purpose of the CBA.

2 Specify set of alternative projects.
3 Identify whole benefits and costs, that count (specify stakeholders of
the policy).
4 Identify impact categories, catalogue them and specify metrics.
5 Predict potential impacts quantitatively over the project lifetime.
6 Monetise all impacts.
7 Discount benefits and costs to get present values of impacts.
8 Compute net present value of each alternative (take difference of
values in item 7).
9 Preform sensitivity analysis.
10 Make recommendations.

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The Basic Steps of CBA

Explain Purpose of the CBA

At this step analyst should state why analysis is being conducted. Some
of the questions, that should be answers are:

What is the problem that is being addressed

What is rational for conducting the analysis?
Is there a market, or government failure?
In practice, clearly identifying the problem is not straightforward.
Normally, analyst should try to identify the source of loosing efficiency. As
a thought exercise one could use Problem Tree approach.

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The Basic Steps of CBA
Specify the set of alternative projects

You always have at least two alternatives: ’Status Quo’ (counterfactual)

and alternative policy

’Status quo’ - is the action without government intervention, or no

change in ongoing policies, or approaches;

’Alternative policy (ies)’ - is the alternative approach, or action that

changes ’status quo’ and an option of interest. Potentially number of such
alternatives could be very large, considering all different ways each option
could be represented.

For example, a hydro power can be built at: different location, with
different size of the dam, different type of the dam, different installed
capacity, different number of generation units etc.
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The Basic Steps of CBA

Specify the set of alternative projects

Sometimes, ’status quo’ could not be kept and an action must be taken.
In such situation common mistake is to think that ’status quo’ in not an
option.

’Status quo’ is always an option, because in quantitative analysis you

need the counterfactual to which you compare your alternative options!!!

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The Basic Steps of CBA

Decide whose benefits and costs count

Decision on whose benefits and costs count depends on:

Depth of the analysis;

Stakeholders involved;
Size of the policy change - small impacts are always expected to all
society, but is counting them worth the effort?
Data availability;
Interests of the client.

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The Basic Steps of CBA

Identify impact categories

Term impact is used to refer to both inputs (resources, costs) and outputs
(benefits, costs).

One could construct impact matrix to formalize all impacts that are
included in the analysis.

It is important to try to include all impact, however for some, data might
not be available, or it might be impossible, very hard, or morally wrong to
monetise impacts (for example life saved).

Consider:, sometimes in identifying impacts some analysts often forget to

include opportunity cost of the resource.

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The Basic Steps of CBA

Predict the impacts quantitatively over the life of the project

In quantitative analysis it is always important, that you are calculating

incremental impacts compared to the ’status quo’ scenario.

Quantitative analysis could normally use different type of models,

mathematical, statistical and econometric. Also, simulation techniques
might be used.

It is important to make it clear what assumptions made, both explicitly

and implicitly, about quantitative models and prediction methods.

In building such models it is always useful to work with sector specialists,

engineers, agronomists, geologists, etc.

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The Basic Steps of CBA

Monetise all impacts

Monetising all impacts is challenging since many of the values could be

hard to calculate or could have moral consequences, such as value of
statistical life.

Monetising benefits normally requires certain knowledge about willingness

to pay (WTP), if markets exists and are well functioning its easy to
calculate. Otherwise it might have to be estimated.

Sometimes, due to challenges in monetising costs, or benefits you might

substitute your analyses with cost-effectiveness, qualitative CBA, or with
multi-goal (or multi-criteria) analysis.

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The Basic Steps of CBA
Discount benefits and costs to obtain present value

Many projects, or policies have impacts that accrue over years. For such
projects you need to have money representing same value over time, as
well as its own opportunity cost - calculate present value (PV).

n
X Bt
PV (B) =
(1 + r )t
t=0
n
X Ct
PV (C ) =
(1 + r )t
t=0

where, r represents discount rate, n is total number of time periods and t

is the time period.
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The Basic Steps of CBA

Compute net present value of each alternative

Net present value of each alternative is difference between PV of

incremental benefits and costs

NPV = PV (B) − PV (C )

If NPV > 0, therefore PV (B) > PV (C ), an alternative is good to go,

otherwise alternative has to be reconsidered.

Select an alternative with largest NPV!

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The Basic Steps of CBA

Perform sensitivity analysis

Your quantitative values are always ”uncertain” to changes in different

assumptions. This has to be addressed to ensure robustness of your results.
Change in assumptions could radically change your NPV estimates,
thus change your conclusion as well.
One could design best case and worst case scenarios, by changing
different assumptions and understanding how change in variables
influences final NPV.
More sophisticated method of sensitivity analysis could be running a
Monte-Carlo simulation, or experimenting with different statistical
distribution of your key parameters.
Note: This is generic meaning of sensitivity analysis, the term is also used
in mathematical programming for similar, but different meaning!
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The Basic Steps of CBA

Make a recommendation

After calculating NPV you might have a situation when one alternative
has higher NPV and higher risk. In this case:
You could suggest preferred alternative by calculating expected NPV
(considering the probability of risk, use distribution of NPV to
calculate its expected value)
Point it out as a trade-off and let decision makers do their job
One could use internal rate of return (IRR) or benefit-cost ratio
indicators as a decision rule
But! Have we actually evaluated an optimal alternative i.e. maximised
NPV at all?

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The Basic Steps of CBA
Example

Figure: CBA seeks

Levan Pavlenishvili (ISET) more
Lecture efficientto CBA
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Use of CBA

Main costumers for CBA could be:

Government - trying to decide on reforms, infrastructure projects, or

push changes in legislature;
Private Sector - for large infrastructure projects influencing society at
large (large hydropowers, ports), or advocate (lobby) certain changes
in legislature;
Civil Society Organisations - trying to advocate for a reform, or
changes in legislature
Thus perception of what constitutes specific costs and benefits depends
whether we are asked about analysts, spenders, or guardians

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The Origins and Demand for CBA

Origins of CBA starts from 17th century England, where argument was
about management of epidemic.

One of the active uses of CBA is in regulatory impact assessment (RIA),

that is compulsory for changes in key legislation in Georgia.

In developed countries, courts are one of the users of CBA to resolve

different cases, especially once related to commercial disputes;

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Costs of doing CBA

Conducting CBA with good quality is costly in different aspects:

Financially, it requires hiring economists with needed background,

professionals in specific sphere and in some occasion mathematicians
for modelling, or simulation;
In terms of time, it could be very time consuming, normally
conducting CBA from ground up takes at least 3 months;
Conducting CBA could be very data consuming in order to keep
results realistic.

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Food for thought

Most CBA models are a quantitative exercise to better understand how

different parameters of the model influence potential outcomes;

Some CBA models could have a role of predicting, or estimating potential

outcomes with certain precision;

Most CBAs are expected to improve decision-making process by

suggesting better alternatives, identifying bottlenecks and suggesting key
implementation aspects;

Modelling social processes is hard, because of many changing parameters,

too small, or too large amount of data.

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