Wednesday, April 8, 2015

How useful is cost benefit analysis?

Yesterday in the public economics workshop at Clemson University Dr. Arnold Harberger, Professor emeritus at the University of Chicago and current professor at UCLA, presented a paper that analyzes the appropriate social discount rate. The social discount rate is the rate that governments use to calculate the net present value (NPV) of a government project.

For example, suppose a government is trying to decide whether they should build a damn or not. For simplicity's sake, lets suppose that the damn will yield benefits of $50,000 per year forever. If the social discount rate is 6%, then the NPV of the benefits of the project is 50,000/0.06 = $833,333. If the cost to build the damn for the government is three annual payments of $300,000 the NPV of the cost is $300,000 + ($300K/1.06) + ($300K/1.06^2) = $850,018. In this case the costs outweigh the benefits so the damn should not be built. However, if the social discount rate is 4% rather than 6%, then the NPV of the benefits is $1,250,000 and the NPV of the costs is $865,828. So when the social discount rate is smaller the project makes economic sense, as it now provides a larger benefit than it costs to produce.

This is a simplistic example but it highlights why the social discount rate is important. Whether a government decides to accept or reject a project often depends on the magnitude of the social discount rate it uses in the analysis.

Now Dr. Harberger is an expert on cost benefit analysis; he has written numerous peer reviewed papers on the topic and has served as an advisor to several national governments. So it can be safely said that he knows what he is talking about. One thing that he stressed is that it is hard to calculate the appropriate social discount rate and that there is some disagreement among economists about which rate is the appropriate one. This has large implications for how tax dollars are spent. One government might use one rate and another might use a different one and thus they come to the opposite conclusion even though everything else is the same. What is even more troubling, as Dr. Harberger noted, is that within the same government different bureaucracies might use different social discount rates. So one bureaucracy might approve a project that another would have rejected.

 Some people incorrectly assume that if the government conducts a cost benefit analysis then whatever decision that results must be the correct one. That is simply not true. Cost benefit analyses are important and they have a role to play, but they are not perfect. Many different assumptions go into a cost benefit analysis, such as the appropriate discount rate, and these assumptions influence the outcome. 

Business also use cost benefit analyses to help them make decisions, but the private sector has an additional mechanism that helps ensure that the best economic decision is made; competition. Different firms may use different discount rates for evaluating their projects and thus they may come to different conclusions, but the market is there to sort out who made the best decision. If Apple decides to launch a new product that Dell calculated would be unprofitable we will eventually find out who made the right decision. If the product is a hit then Apple made the right choice and Dell blew it. If the product fails then Dell was right after all.

Cost benefit mistakes don't matter as much in the private sector because the firm who makes the mistake ultimately bears the cost. Unfortunately the Federal government doesn't have much competition. Sure US officials can learn from the mistakes of Canadian officials, but there are so many differences between countries even as similar as the US and Canada that it would be hard to convince people that what didn't work in Canada would also not work in the US. If the dam that I talked about above ended up being built, how would we ever know it was the wrong choice? Ex post, after it was built, maybe government officials will analyze the costs and benefits and admit that it made a wrong decision, but even if they do, then what? The fixed costs are sunk at that point so it likely will not make sense to quit operating it. Instead it will simply be a government mistake that resulted in wasted tax payer dollars. Perhaps the government will learn from that mistake but unless the mistake leads to someone being fired or voted out of office there isn't really much of an incentive for officials to change their behavior.

The market is the ultimate correcting mechanism. Without competition we are forced to rely on faulty cost benefit analyses that can never be perfect. Now the market is not perfect either and some resources will be wasted by firms that create products that people ultimately don't want. But profit and loss ensure that firms will be very careful when they do their calculations as well as ensure that firms learn from their mistakes. Governments are not concerned with profit and loss and political concerns usually outweigh economic concerns.

So while cost benefit analyses can be useful, they are not a panacea. It is important that people are aware of the limitations of cost benefit analyses so that the government does not abuse them. The fewer decisions that are made that rely solely on cost benefit analysis the better off our society will be.

No comments:

Post a Comment