Chapter VIII

Social Cost Benefit Analysis

It became important in late 1960s and early 1970s
(Public Projects)
Social Cost Benefit Analysis (SCBA) is a tool
developed for evaluating projects from the society’s
point of view
It is used mainly to evaluate public projects.
Now a days it is also getting importance in private
investment project as they have to be approved by
different government agencies.
SCBA is different from financial analysis in that,
 Financial analysis takes into account only those
costs and benefits falling on the decision maker
 It also focus only on those tangible benefit or
costs
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 Social Cost Benefit Analysis(Cont …)
In General, SCBA is a social decision making
machinery, which evaluate all major intangible
costs and benefits arising form a contemplated
course of action
 Need for SCBA?
Financial Cost-benefit analysis is quite
successful in quantifying the tangible benefits
and costs so as to choose the best project with
the highest BCR or NPV
However, such analysis failed to evaluate or
assign value for intangibles like, benefit to the
natural environment and to the society
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 Social Cost Benefit Analysis(Cont …)
The essence of the SCBA is that the actual
receipts of a project do not include or reflect
the social benefits of the project
The actual expenditures does not include social
costs either
The reason is that market prices may be
inadequate indicator of economic benefits and
costs.
Which means some projects which seems very
profitable when they are valued at market prices
might be unattractive from the viewpoint of the
society,
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 Social Cost Benefit Analysis(Cont …)
As a result, SCBA deviate from the financial
(private) cost and benefit of the project.
The major sources of differences are due to
market failure
The market price which forms the basis for
computing the monetary cost and benefit from
the point of view of the project owner will not
reflect social values
This is due to the existence of
Public Goods ( Collectively consumed goods)
Externalities
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 Social Cost Benefit Analysis(Cont …)
Public Good (Collectively consumed goods)
These are goods served (consumed) on the basis first
come first serve.
Public goods are goods that are
Non-excludable: It is not possible to exclude others
from consuming public goods
Non rival in consumption: Once they are available the
additional consumption up to capacity constraint does
not reduce the availability of the good
The free rider problem arises when a consumer or
producer doesn't pay for the use of them
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 Social Cost Benefit Analysis(Cont …)
Externality
Due to the existence of public goods (collectively
consumed good) for which every one has free
ride, the problem of externality exists
Market fails to assign value to externalities as
they occur outside the market transaction.
Externality is said to be exist when the
production / consumption activity of one party
affects the production/consumption activity of
another party without any payment for the
effect
Externality can be either positive or negative
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 Social Cost Benefit Analysis(Cont …)
Negative externalities
Project may have a harmful external effect like
pollution
 pollution produced by local automobiles,
 Sound produced by economic agents
 Water pollution by a steel industry
Positive externalities:
Project may create certain infrastructure
facilities like road which will benefit people in
the nearby community
 pleasure from observing your neighbor's flower
garden
 an orchard located next to a beekeeper.
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 Social Cost Benefit Analysis(Cont …)
If there are externalities, there is deviation
between private and social benefits and costs.
The equilibrium condition for the private decision-
maker is Marginal Private Cost (MPC) equals to
Marginal Private Benefit (MPB), i.e., MPC=MPB
For the society, an efficient allocation requires
that Marginal Social Cost (MSC) equals to Marginal
Social benefit (MSB), i.e., MSC =MSB .
If there is positive externality in production the
firm produces at point where MPB = MPC. But this
is different from the socially efficient level as
MSB (= MPB+MEB) > MPB. (E=External )
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 Social Cost Benefit Analysis(Cont …)
Such positive or harmful effects of the project
are not valued by the market as they are
intangible and the transaction takes place
outside the market.
Redistribution effect: A private project mostly
are not concerned how the benefits are
distributed across various groups in the society.
The society is , however, concerned with the
distribution of benefits across different
groups.
In the SCBA redistribution effect of the
proposed project is also considers in evaluating
the project.
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 Social Cost Benefit Analysis(Cont …)
In choosing a particular project the additional
benefits derived from a particular project should
exceed the corresponding additional cost
The cost benefit analysis can be undertaken in
three steps
Step-1: This step involves the identification of
alternatives to be assessed.

Step-2: In this step a prediction of the likely

consequences associated with each alternative
projects
This means the likely effect of the project on the
social and environmental aspects is predicted
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 Social Cost Benefit Analysis(Cont …)
For Example:
Consider a development project - Construction of Dam.
In this step the possible intangible benefits that a
project may bring to the community and on the
environment is predicted.
These are benefits like,
The number of unemployed people that would get
employment opportunity
Benefit obtained from the infrastructure improvement
(saved time , reduced cost, etc.)
Decrease yearly flood damage (soil erosion, deforestation,
reduced property damage )
Recreational benefit to the society

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 Social Cost Benefit Analysis(Cont …)

Intangible Cost (harmful impact of the project)

 Deforestation created by the project
 Number of people displaced from the site

Example 2
Consider the Railway project:
Here we need also to identify and describe
changes that can be brought out by the project
in the transport sector.
The Railway projects might have the following
social benefits and costs
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 Social Cost Benefit Analysis(Cont …)
Potential benefits:
It reduces motor vehicles operation and
maintenance cost to both government and
private sector as they switch over from road to
railways.
It will reduce travel time of people using the
road (opportunity cost of time)
Reduce atmospheric pollution in the city
Reduce investment and operation cost of road
Reduce traffic accident in the city
Expected cost of the project
Loss of revenue to private investor
Number of people losing their job 13
 Social Cost Benefit Analysis(Cont …)
Step-3: Involves the task of estimating
(assigning) values for the cost and benefits
occurring as a result of implementing the
project
Estimating the cost or the benefit of intangibles
is some what difficult and require the application
of both direct and indirect method.
Consider the case of a project that might cause
damage on the environment say, west disposal to
the river or air pollution
Let us consider the nature of the cost involved in
environmental quality (cost valuation)
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 Social Cost Benefit Analysis(Cont …)
Cost of environmental problem refers to the
west disposal cost imposed on the society by
the production and consumption activities of the
project
West Disposal Cost: is the sum of pollution
prevention cost and pollution cost (i.e.,)
West Disposal Cost = Pollution Prevention Cost +
Cost of Pollution
Pollution Prevention Cost: are those costs incurred
to prevent the pollution either partly or fully.
These are costs like,
Costs incurred by local government (society) to
treat its sewage before dumping it into the river.
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 Social Cost Benefit Analysis(Cont …)

One example of social cost of pollution prevention

is
the additional transport cost accepted by
suburban dwellers who work in a city.
Some people prefer to reside in suburbs and
incur additional expense on transport rather
than be a part of the polluted atmosphere in
the city.
These costs are incurred for the purpose of
avoiding the problem of congested city and
hence come under pollution prevention cost.
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 Social Cost Benefit Analysis(Cont …)

Pollution Cost: these can be either pollution

avoidance cost or welfare damage cost.
Pollution avoidance costs: are private or public
expenditure made to avoided pollution damage
once pollution has already occurred
Once the environmental damage has occurred a
society can choose either to avoid the damage
through some remedial measure or to bear it
The cost of such measure is considered as a best
estimate to value the damage (cost of the
project)
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 Social Cost Benefit Analysis(Cont …)

Welfare Damage: The damage that are neither

prevented nor avoided cause welfare damage.
Such damages are both real and financial.
These are observable deterioration of physical
asset and properties.
It can also be in the form of deterioration of
the health of living beings.
Projects that results in water and air pollution
create health hazards and increase the
medical expense to the society to maintain a
given standard of health
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 Social Cost Benefit Analysis(Cont …)

There are, certain welfare costs of pollution

damage which can not be directly measured.
At most we can measure them by finding out
sum of money needed to pay to avoid such
damage.
In general,
West Disposal Cost = Pollution Prevention
Cost + Pollution Cost
Pollution Cost = Pollution Avoidance Cost +
Welfare Damage Cost
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 Social Cost Benefit Analysis(Cont …)
Waste disposal costs are in general alternative
costs of real cost
That is, direct and indirect outlays that could
be incurred either to prevent pollution before
it occurred or to avoid the damage from
pollution after it has occurred.
The pollution damage cost to the society
increases with pollution increase.
This is shown in the diagram below

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 Social Cost Benefit Analysis(Cont …)
TDC (Total Damage Cost)
Cost

Pollution

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 Social Cost Benefit Analysis(Cont …)
Cost of pollution control increases as a
society attempts to decrease the damage (or
to increase environmental quality)
This reflects the fact that the more pollution
is reduced the higher will be the cost to the
society in effort to control an additional unit
of pollution
The following graph shows the relationship
between the cost of damage control with the
level of damage
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 Social Cost Benefit Analysis(Cont …)
Cost TCC (Total Cost Control)

Low High Level of Damage (Pollution)

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 Social Cost Benefit Analysis(Cont …)

The reasonable goal of the society is to

minimize the sum of the Total Damage
Cost of pollution and the Total Cost of
Controlling pollution. i.e.,

Min TDC + TCC

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 Social Cost Benefit Analysis(Cont …)
TCC

Cost
TCC TDC
TDC TCC+TDC

Pollution
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 Social Cost Benefit Analysis(Cont …)

Cost
MCC MCC
M DC MDC

A
B

O Poptm. K Pollution
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 Social Cost Benefit Analysis(Cont …)

The pollution level OK represents a

situation where MDC > MCC
The marginal damage for the society is
higher than its cost of control
Generally the cost of damage inflicted
by the project can be estimated by
considering the above cost concepts
of west disposal.
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 Social Cost Benefit Analysis(Cont …)
How to evaluate benefits of environmental
quality improvement ( of the project)?
Most of the adverse consequence of development
projects are due to collectively consumed goods
and externalities and most of such consequences
are environmental in nature

Almost all types of economic activities have a

profound impact on a natural as well as social
environment.
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 Social Cost Benefit Analysis(Cont …)
The economic activities of production and
consumption relay up on the environment’s role
as a resource suppliers and as a waste
assimilator.
Thus, properly valuing project’s effect that
brings improvement on natural environment is
an important issue in project appraisal.

Such proper valuation is important because,

It signals the growing scarcity of the natural
recourses

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 Social Cost Benefit Analysis(Cont …)
It helps the decision making which involves a
conflict between development and
conservation
It helps the decision makers to include
 non quantifiable,
 subjective variables
in decision making so that the true economic
value of the project is considered for
decision making

It helps to adopt the appropriate policy mix

for decision making.
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 Social Cost Benefit Analysis(Cont …)

Direct methods Indirect Method

Conventional Hedonic Cost based

1. Contingent Market approach Approach methods
valuation
method
2. Trade of
games method 1.Household Production
1. Productivity
3. Costless function approach 1.Replacement
approach a Travel Cost approach Cost approach
choice method 2.Human capital or b. Preventive 2. Relocation
4. Delphi foreign earning expenditure approach
cost approach
Technique approach 2. Surrogate Market
approach 3. Opportunity
3. Dose response
a. Property Value cost approach
approach
approach
b. Wage Differential
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approach
 Social Cost Benefit Analysis(Cont …)
I. Direct method
Direct methods are largely based on survey
These methods are useful in valuating the benefit
of a project where indirect methods are
inadequate.
Direct method is an attempt to elicit preference
directly by the use of survey and experimental
technique
Here belong methods like,
 Contingent valuation method (CVM)
 Trade of game methods
 Costless choice methods
 Delphi method
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 Social Cost Benefit Analysis(Cont …)
Trade off game method: Trade of games are
used to determine individual preferences
among verities of outcomes.
To understand this simply let us assume that
there are two parts of each outcome.
A certain sum of money and a certain quality
of environmental or social goods
The base outcomes are a combination of
certain level of environmental quality plus no
money
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Social Cost Benefit Analysis(Cont …)

OUTCOME ONE: Base outcome

Environmental quality
No Money

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 Outcome two
Improved quality of environment plus certain
amount of money (cost to the society)

Outcome two: Willingness to pay

for certain level of environmental
quality

Improved quality of
Environment or social goods Certain amount of
money

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 Social Cost Benefit Analysis(Cont …)
The individual is asked to reveal his preference
between the two outcomes.
The amount of money in the outcome two is the
amount that the individual is willing to trade off for
the improvement of the environmental quality
specified in the option.
The value of this trade of money is increased
gradually until the individual decide to be
indifferent between the two outcomes.
The amount which makes him indifferent between
the two outcome is his willingness to pay for the
specified increase in the environmental quality of
goods.
By interviewing an adequate size of population the
willingness to pay is estimated. 36
 Social Cost Benefit Analysis(Cont …)
2. Indirect Method
These are the method largely used on the basis
of actual peoples behavior in contrast to the use
of hypothetical situation.
The direct method could be of the following
type
a) Conventional Market Based Approach
b) Hedonic Pricing Approach: Which can be either
 Household production function approach
 Surrogate market approach
c) Cost based method
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 Social Cost Benefit Analysis(Cont …)

Conventional Market Based Approach:

This method of valuating benefit relies
on the actual market price of the
product, the production of which has
consequence on environment.
This approach may take the form of
Productivity approach
Human capital or Foregone earning
approach
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 Social Cost Benefit Analysis(Cont …)

The productivity approach: In this method

environmental factors are viewed as a factor of
production.
Change in environmental quality lead to changes in
productivity which in turn will affect the price of
the product through a change in output.
Such changes can be observed and measured.
For example,
A reduction in soil erosion may increase yields.
Comparison of output with and without soil
conservation scheme shows the difference in
productivity arising from soil conservation.
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 Social Cost Benefit Analysis(Cont …)
Like wise, improvement in the water supply by
reducing salinity may improve the crop
productivity.
Similarly a project which brings adverse
effect on the quality of soil (erosion or
pollution) may result in reduction in crop
production.
In such project which results in water quality
improvement (soil quality), change in the
output multiplied by the price of output give
us an estimate of the benefit / cost of the
project.
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 Social Cost Benefit Analysis(Cont …)

Thus, in the productivity approach a

change in environmental factors is said to
influence the production function and hence
the supply of marketable goods from the
given resources.
The value of change estimated through the
market price of the goods is hence used as a
measure of the benefit or loss resulting from
a change in environmental quality.

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Social Cost Benefit Analysis(Cont …)

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