Cost-benefit analysis

Cost-benefit analysis is used to evaluate projects that generate non-financial costs and benefits, taking account of the preferences of those affected. It has applications to the provision of public goods for which preferences are not reflected in market prices. Although its quantitative results are necessarily approximate, it can sometimes provide a persuasive guide to a choice among alternatives. It is claimed that, by taking account of the strengths of preferences, cost-benefit analysis can provide a better guide to choice than can be obtained from voting.

Introduction

The function of cost-benefit analysis is to inform a decision that is to be taken on behalf of others. Its purpose is to indicate whether the proposed decision would be consistent with the preferences of those affected. The actions required are:

• the specification of the scope of the analysis and of the decision criterion to be used;
• the forecasting of the material consequences of the proposed decision;
• the monetary valuation of each consequence in light of the preferences of those that would be affected;
• the aggregation of those valuations as required in order to apply the decision criterion; and,
• the interpretation of the aggregated valuations.

Specification

Scope

The scope of an analysis is normally determined by the requirements of its prospective users. The evaluation of a medical procedure might, for example, be concerned solely with its effects on patients and their families, or it might also encompass effects on the hospital or on the public at large. An evaluation of migration commissioned by a European government might or might not be required to include effects upon migrants and their families, but an evaluation commissioned by the European Union might be expected to require the inclusion of effects upon all of its inhabitants. Some users require the coverage of a longer timescale than others, and environmental studies may even be required to encompass effects on future generations.

Criterion

The customary ("consequentialist") decision criterion of cost-benefit analysis uses the summation of the effects of the expected consequences of a decision on the well-being of people within its scope. The alternative ("deontologist") decision criterion takes account of predetermined rules that reflect the beliefs or customs of the community concerned. To make a summation possible, a monetary cost or benefit is assigned to each of those effects. The summation normally used is then that of the costs and benefits of each effect, weighted by their estimated probability of occurrence, and discounted using the estimated time preference rates of those affected. The normal acceptance criterion for a single project is a positive net present expected value of the excess of benefits over costs, and the normal criterion for the acceptance of one among several alternatives is that it should be the one with the highest net present expected value. Some authorities specify a required rate of return criterion, but that has the disadvantage that the associated internal rate of return calculation can sometimes produce inconsistent results .

Methodology

Forecasts

The practice of cost-benefit analysis depends upon the assumption that - although the acceptability of the consequences a decision is determined by the reactions of those affected - the forecasting of those consequences is the responsibility of the decision-maker. That responsibility is assumed to be delegated to a representative government by its voters (and also, for example, to a medical practitioner by his patients). It is here assumed that forecasts of all of the expected outcomes and their probabilities are already available.

Valuation

The outcomes whose valuations typically figure in cost-benefit analysis, include non-financial benefits such as the saving of time and the relief of suffering, and non-financial costs in the form of unwelcome experiences such as injury and exposure to noise. The monetary value to a person of such an outcome is taken to be the amount that he would be willing to pay in order to enjoy its benefits or avoid its costs. The preferred way of estimating the relevant willingness to pay is the revealed willingness to pay method, which depends upon observations of the subjects' conduct in making free and well-informed choices. Valuation can be reliably estimated from the price that is determined by choices made in an efficient market, a reasonable approximation to which is often provided by organised markets for products and services. An alternative is the contingent valuation method which employs survey questionnaires to establish the subjects' stated willingness to pay. Another possibility is the valuation of particular outcomes according to the observed community willingness to pay in expression of its collective attitude to similar outcomes. (Under that approach, the value of life might be derived from the costs of communally-determined practices concerning its preservation, such as prolonged hospitalisation).

Aggregation

The preferred method of aggregation is to calculate the sum of the net present expected values of all the outcomes, using their estimated probabilities and the appropriate discount rate. An exception is the practice (adopted in some assessments of global warming) of assessing the value of a "worst case scenario" when probability estimates are not available.

Applications

Health and safety

Estimates of the value of a life have featured in cost-benefit analyses of medical programmes, road safety schemes and health and safety regulations. The evidence on which they are based has come mainly from studies of the market tradeoffs between money and fatality risks, and mainly from the analysis of the premiums paid to employees to compensate them for undertaking risky work. Such risk premium studies have been shown to imply values of life ranging from less than a million dollars to over 20 million (at 2000 prices), rising with income and falling with age. It seems unlikely that contingent valuation estimates exhibit less scatter.

The available evidence thus leaves the users of cost-benefit analysis with a wide range of choice. The values that have been adopted include:-

• United States Department of Transportation. Value of a statistical life: $5.8 million @ 2007 prices (range $3.2 to $8.4 million).
• European Commission. Value of a death from environmental pollution (age adjusted): €1 million @ 2000 prices (range €0.65 to €2.5 million) .
• United Kingdom Department for Transport. Average value of prevention per fatal casualty: £1.43 million @ 2005 prices (human cost £0.94 million, lost output £0.49 million)
  

The US figures are based mainly on revealed willingness to pay (risk premium) studies, and the European figures are based mainly on stated willingness to pay (contingent valuation) studies.

Metrics used in cost-benefit analyses

• Cost per year of life saved The definition of an acceptable cost per year of life saves ranges from $50,000 to $200,000.
• Cost of Preventing an Event (COPE) For example, to prevent a major vascular event n a high-risk adult , the number needed to treat is 19, the number of years of treatment are 5, and the daily cost of the generic drug is 68 cents. The COPE is 19 * 5 * ( 365 * .68) which equals $23,579 in the United States.
• Years (or months or days) of life saved. "A gain in life expectancy of a month from a preventive intervention targeted at populations at average risk and a gain of a year from a preventive intervention targeted at populations at elevated risk can both be considered large."
• Quality-Adjusted Years of Life saved and Disability-Adjusted Years of Life saved. These are compound metrics that considers both the gain in duration life, adjusted by factors reflecting overall health and ability to function in those years.

Standards in conducting a cost-benefit analysis

Standards have been developed for the conduct of cost-benefit analyses and for systematic reviews of cost-benefit analyses.

The two most common problems in publications of cost-benefit analyses are not stating the study perspective (e.g. is the cost born by the patient, health case system, or society) and not disclosing the funding source.

Difficulties in cost-benefit analyses

The costs saved by successful treatment of one disease may be offset by greater longevity leading to increased costs from other disease.

Recommendations have bee published on how to read and interpret a cost-benefit analysis.