(CHAPTER 2: CONCEPTUAL FOUNDATIONS OF COST:BENEFIT ANALYSIS Purpose: Providing bass for determining when CBA cao be ust asa decison rule, when it ‘em be used asa pat ofa broader analysis and when it should be avoided. This is done by introducing the notion of Pareto (allocative) efficeney, which provides the conceptual basis far (CHA, snd is relation to potential Pareto ficiency, wc asa practical basis for CBA. CBA AS A METHOD FOR MEASURING EFFICIENCY CCBA is method for measuring eficincy Le, the sation in which resources are deployed in ‘hee highest valued uses in terms of goods and sevies they produce. When efciency i hen ‘the enly goal be achieved, CBA provides a framework to compare altrative policies. this is no the ase, then CBA ean be used to provide information about the relative efficiency of alternative police. Pareto eicincy: An allocation of goods is Pato efficient if no alternative allocation can make atleast one person beter of wil! making anyone else worse of [Net Benefits and Pareto Eiieney ‘The link between net benefits and Parcio efficiency is simightorward: iff net benefits are positive, thn iis possible to ind a set of transfers that make at eas! one pers beter Of Without’ making anyone ese worse off, A full understanding of this ik requires the Understanding ofthe notions of willingness to pay and opportunity cost Witingnes to Pay (WTP) isthe payment that one would have to make or revive under the policy so one would be indfeent betwen the satus guo and he poiey with the payment ‘The algebraic sum ofthe WIP values is the appropri measure af the net benefits ofthe impacts of pli Ifand ony ithe agaregat et bona ofthe policy (as measured by WTP ‘of affected individuals) are postive, then there exist ase of contbutens and payments tht make a Pareto improvement over the satus quo. Opportunity Cost places a dollar value on inputs required 10 implement polices. The ‘ppertuity ost of an inputs value in ts best aemative use Using CBA for Decision Making all impacts are valued using WTP and al inputs are valued using opportunity costs, then the sign of net benoit indicates i itis possible o increase Part efficiency. Using & decision ule to implement only Pareto efficient pois is impractical forthe following reasons ‘The information burden of measuring benefits and costs for each individual, {© Theadminsvatve burden of actually making each required wars. ‘© Compensation would induce people to overstate costs and understate benefits ential Pareto Eicleney (Le. Kaldor-Hicks criterion) Altemative decision rule: Adopt only polices hat have positive net benefits. Reasons for adopting it oles easble 1 Society maximizes agerente wealth ‘If dierent poices have diferent winners and losers, the, in aggregate, costs and benefits ‘will average out over the entire population ‘© I counters incetive to give too moch weight to organized groups and to litle weight to ‘unorganized groups ‘© It ispossibeto do rdistrbution wholesale ther than within each separate pli. Applicaton ofthe Decision Rule in Practice 1. Adopt al poices hat have postive net benefits (all policies are independent). 2 I policies itr or enhance each other, choose the combination of policics that maximizes et benefits 4, net: Coxt Ratio = ReneivCost A. The buanliticust retio ome confine choice: Does one choose the policy with the best retie orre eee ee ee ‘because the ratio can be manipulated (Le, i something a negative Benet ora postive coe) 5, Care mus be taken to determin interactions among projets so that combinations of projects providing the greatest aggrepate net benefits can be idenlfed (ue. ind interferences and syns). FUNDAMENTAL ISSUES RELATED TO WIP. ‘Theoretical Limitations of WTP as Basis for Social Orderings 4 Thera for cresting a social ranking of alteratves snot fly satisfctry. Gener Posi: Theorem (GPT) K. Arow (1981) proved that any soil ehoiee rl that stiles hist of mess condone could proce Magia es. The onions are Individuals may have any transitive references (axiom of unrestricted domain. + IW alimatvel is unanimously preted by all individuals over altemative 2, then erative 2 should not be eosen (axiom of Parco choice) + ‘The ranking of two alematives should aot depend on what other altematives are lable (axiom of independence). + Noone person should have dictatorial powe (axiom of nondittorship) (GPT stats that any rule that sates all four conditions will lt ensue a tansive social