Cost-Benefit Analysis and Compensation Criteria | UGC NET Economics – Notes

Cost Benefit Analysis

Introduction

• Cost-Benefit analysis (CBA) is a technique which is used to appraise and evaluate projects. The basic idea in CBA is quite simple: first identify the costs and benefits of a project and then measure them in comparable units (say in terms of money, and expressed in a single currency). Compare the benefits and the costs. If the benefits exceed the costs, the project should be accepted as resource allocation will be efficient. If, on the other hand, costs exceed benefits, then reject the project.

• The desirability or feasibility of projects, whether in the private or public sector are adjudged on the basis of criteria that are rooted in the concept of profits. Profitability is contingent upon the likely costs that the project entails, and the likely returns that it generates. The two sectors, public and private, however may differ (sometimes widely) on the explicit recognition of the prices at which the value of output and the cost of inputs are to be evaluated. While the analysis of projects in the private sector generally incorporates the direct and financial costs and benefits only, the analysis of public sector projects attempts to encompass the indirect and non-financial costs also.

• However, once prices of both inputs and outputs are agreed upon, any project for which revenues exceed the cost is desirable. However, since resources are finite, those that generate the maximum profitability would get priority. To evaluate projects over a lifetime, we must have its returns as well as costs in all future periods.

• When the private sector is faced with a choice between more than one project, it has to rank projects in terms of profitability. The net present value (NPV) is one such criterion to evaluate a project. For any project which has a cost (C), in the present period and a return of (R) over the coming two periods and if (r) be the market interest rate, then the net present value of a project would be:

$$NPV = -C + \frac{R_{1}}{(1+r)} + \frac{R_{2}}{(1+r)^{2}}$$

• If the net present value of the project is positive, it should be undertaken; if not, then not. If there is a choice between more than one project, the one with the highest net present value should be chosen.

• Another measure of profitability is the internal rate of return (IRR), which is that rate of interest which makes the net present value equal to zero. If the internal rate of return is higher than the net present value, the investment is worth undertaking; if not, then not. However, since the internal rate of return gives no indication of size. It may sometimes be better to undertake projects with lower internal rate of return, if the magnitude of the project is of concern.

• The difference in the analysis of projects across sectors arises out of choice of prices to estimate profitability (feasibility/ desirability). In most private sector projects, the prices chosen are the prevalent and observable domestic market prices. However, these prices are largely perceived to be inappropriate to adjudge the feasibility of public sector projects.