Chapter 2: Conceptual

Foundations of CBA
Seungyoon Jeong
University of Minnesota

Week 2 – Fall 2021

CBA As Framework For Measuring Efficiency
• CBA can be thought as providing a framework for measuring efficiency

• A broad notion of efficiency:

- situation in which resources are deployed in their highest valued uses

- or best possible way to allocate inputs

• Definition of Pareto Efficiency:

- an allocation is Pareto Efficient if there is no other feasible allocation that can make someone better
off without making someone else worseoff↵
Pareto Efficiency: An Example
• Idea of example:
- two persons will receive any total amount of money of up to $100 if they agree on how to split it
between themselves

- if they do not agree, each receives $25 (disagreement point)

• Potential Pareto Frontier: all feasible splits between the two persons that allocate the entire $100

• Pareto Frontier:
- segment of Potential Pareto Frontier that gives each person at least as much as status quo

- only on the Potential Pareto Frontier it is not possible to make a feasible reallocation that makes
one agent better off without making the other one worse off
Pareto Frontier
Net Benefits and Pareto Efficiency
• The link between positive net social benefits and Pareto efficiency
: If a policy has positive net benefits, then it is possible to find a set of transfers that makes at least
one person better off without making anyone else worse off

• This requires a method for valuing the outputs of a policy and a method for valuing the resources required
to implement the policy

• Here we use, Willingness-to-Pay (WTP) for the former and Opportunity costs for the letter
Net Benefits and Pareto Efficiency: Example
• Example of a policy:
- Person 1: WTP = $100
- Person 2: WTP = $200
- Person 3: WTP = -$250
- Benefits: $100 + $200 = $300
- Costs: $250
- Net benefits: $50

• Consider a Transfer Scheme:

- Person 1 pays $75 to person 3, and Person 2 pays $175 to person 3

• Key point: If aggregate net benefits as measured by WTP is positive, then there exists a transfer scheme that
would make the policy a Pareto improvement over the status quo

• Simply implementing the policy would not be Pareto Efficient as person 3 would be worse off
Net Benefits and Pareto Efficiency: Example
• Implementation of policies (almost always) requires the use of inputs that could be used to produce other
things
- example: inputs (concrete, machinery, workers) to construct a bridge

• Opportunity costs (OC) of an input is its value in its best alternative use

• Previous example (remember the aggregate WTP for the policy is $50)
- if OC of inputs was $75, would it still be worth?
- if OC of inputs was $20?

• As long as all impacts are in terms of WTP and all inputs in terms of OC, the sign of the net benefits indicates
whether it would be possible to come with a transfer scheme

• Practical Problems:
- high informational burden: people do lie
- administrative costs
Net Benefits and Pareto Efficiency: Example
• Put differently the link between net benefits and Pareto efficiency,
- As long as analysts value all impacts in terms of willingness-to-pay (WTP) and value all required
inputs in terms of opportunity costs, then the sign of the net benefits indicates whether it would be
possible to compensate those who bear costs sufficiently so that no one is made worse off and at
least one person is better off

• This requires more broad concepts of efficiency because Pareto Efficiency does not say anything about
“Compensation”

• Kaldor-Hicks Efficiency: A reallocation is a Kaldor-Hicks improvement if those that are made better off could
hypothetically compensate those that are made worse off and lead to a Pareto-improving outcome
- Kaldor-Hicks Criterion: Policy should be adopted if and only if those who will gain could fully
compensate those who will be lose and still be better off

• Net benefit Criterion: adopt only policies that have positive net benefits
Net Benefits and Pareto Efficiency: Example
• Put differently the link between net benefits and Pareto efficiency,
- As long as analysts value all impacts in terms of willingness-to-pay (WTP) and value all required
inputs in terms of opportunity costs, then the sign of the net benefits indicates whether it would be
possible to compensate those who bear costs sufficiently so that no one is made worse off and at
least one person is better off

• This requires more broad concepts of efficiency because Pareto Efficiency does not say anything about
“Compensation”

• Kaldor-Hicks Efficiency: A reallocation is a Kaldor-Hicks improvement if those that are made better off could
hypothetically compensate those that are made worse off and lead to a Pareto-improving outcome
- Kaldor-Hicks Criterion: Policy should be adopted if and only if those who will gain could fully
compensate those who will be lose and still be better off

• Net benefit Criterion: adopt only policies that have positive net benefits
Net Benefits and Pareto Efficiency: Example
• Two policies can be thought of as independent if the adoption of one does not influence the costs and
benefits of the other.
• When all relevant projects are independent, the CBA decision rule is: to adopt all policies that have positive
net benefits

• No constraint: Choose A, B and combination of C and D (net benefits: $43 millions)

• If all projects are mutually exclusive: Choose B (net benefits: $20 millions)
• Total cost less than $10 million: Choose A and combination of C and D (net benefits: $23 millions)
Pareto vs. Kaldor-Hicks
Possible Problem of Kaldor-Hicks: Scitovsky paradox
Allocation E Allocation F
Tom Jessica Tom Jessica
Apple 2 0 1 0
Banana 0 1 0 2
Tom Jessica
Preference order 1st 2nd 3rd 1st 2nd 3rd
Apple 1 2 1 1 0 0
Banana 1 0 0 1 2 1
• Consider moving from E -> E’. If Jessica gives one unit of banana to Tom, Tom’s utility increases, while Jessica
stays the same. Thus, this is Kaldor-Hicks improvement

• Consider moving from E’ -> E. If Tom gives one unit of apple to Jessica, Jessica’s utility increases, while Tom
stays the same. Thus, this is Kaldor-Hicks improvement

• E’ is dominant E, and E is dominant E’ in a sense of Kaldor-Hicks efficient. Thus, this is indeterminate

Fundamental Issues Related to WTP
• Social Choice Theory

• How to aggregate each individual preference?

• One of the common aggregation procedure is: Majority Voting
Consequentialist argument for majority voting
• Condorcet’s jury Theorem:
- If each member of a jury has an equal and independent chance better than random, but worse
than perfect, of making a correct judgment on whether a defendant is guilty (or on some other
factual proposition), the majority of jurors is more likely to be correct than each individual juror,
and the probability of a correct majority judgment approaches 1 as the jury size increases. Thus,
under certain conditions, majority rule is good at tracking the truth. Although the jury theorem is
often invoked to establish the epistemic merits of democracy, its assumptions are highly idealistic.

• Condorcet’s Paradox
- Majority preferences can be irrational (specifically, intransitive) even when individual preferences
are rational (specifically, transitive)

• Remember, the axiom Transitivity:

- If X is preferred to Y, and Y is preferred to Z, then X is preferred to Z.
Net Benefits and Pareto Efficiency: Example

• Majority rule voting over pairs of alternatives:

- choice between X and Y: 2 votes for X, 1 for Y
- choice between Y and Z: 2 votes for Y, 1 for Z
- choice between X and Z: 2 votes for Z, 1 for X

• In pairwise voting:
- X is preferred to Y, Y is preferred to Z, but Z is preferred to X!
- Social preference is intransitive
- Majority voting fails