"Benefit-Cost Analysis"
17 Apr 2006 in Regulatory Economics, Information Quality, Glossary
This is a tool widely used by economists to provide a
structured understanding of the pros and cons of regulatory
alternatives. Among non-economists, however, it is widely
misunderstood.
"Pros" on one side of the scale are the benefits that are expected to
result from taking regulatory action. Benefits can take many forms, but
they consist of the value that people place on the goods and services
that a regulation is expected to produce. Economists try to convert
benefits into dollars (or some other monetary unit) to
facilitate
comparison with cost. Monetization
can be simple and uncontroversial, or difficult, highly contested and
subject to serious manipulation. This is especially true when benefits
or costs arise in the form of changes in risk to health,
safety or
the environment. Although there is no question that people value these
things, estimating how much they value them can be difficult.
"Cons" on the other side of the scale are the costs that must be borne
to comply with regulatory standards or requirements. Costs are almost
always thought of as expenditures in dollars (or some other monetary
unit), but this is always incorrect. Properly understood, cost
is the value
of benefits foregone
by devoting resources toward this purpose instead of their highest and
best use. One must estimate expenditures, determine where
these
expenditures otherwise would have been made, identify the benefits that
would have accrued from these expenditures, and finally value the
benefits that would must be foregone. This is complicated, and
rarely if ever done.
Generally, cost exceeds expenditures. That means expenditure is an inaccurate
measure
of cost. A lot of effort often is devoted to producing very
precise measures or estimates of expenditure, but the resulting values
are systematically biased to understate costs. Because they are
systematically biased, they are not objective
within the meaning of the federal Information Quality Act.
Regulatory benefit-cost analyses frequently suffer from systematic
biases that understate costs and overstate benefits. Costs are
systematically understated by the use of expenditures as a proxy.
Benefits are systematically overstated by the use of
quantitative
risk assessments as inputs. Conventional risk assessment practice
embeds systematic upward bias in the estimation of health
risk.
For example, U.S. EPA's Staff
Paper on Risk Assessment Principles and Practices clearly
states
that, as a matter of policy, the Agency's human health risk assessments
are more likely to overstate than understate risk:
"Knowingly underestimate" and "grossly overestimate" are not equivalent constructs. That is the very definition of bias.
The accepted way to evaluate each regulatory alternative is to subtract (unbiased) estimates of cost from (unbiased) estimates of benefit. Ideally, cost would be subtracted from benefit for each affected person and these differences would be summed across the affected population. Alternatives can then be ranked in descending order of net benefits. In practice, however, unbiased estimates of average cost and benefit have proved to be elusive, in large part for the reasons described above. Thus, rankings of regulatory alternatives can be fraught with uncertainty and must be interpreted with great care and caution.
The U.S. Office of Management and Budget has published several government-wide guidance documents on how to perform benefit-cost analysis of regulatory actions:
- 1991: "Regulatory Impact Analysis Guidance (Appendix V in the 1990-91 edition of the then-annual Regulatory Program of the United States, not on line)
- 1996: "Economic Analysis of Federal Regulations"
- 2000: "Guidelines to Standardize Measures of Costs and Benefits and the Format of Accounting Statements"
- 2003: "Regulatory Analysis" (OMB Circular A-4)
Benefit-cost analysis and cost-benefit analysis are the same thing. However, these terms have somewhat different origins, and sometimes how they are used betrays a point of view about the legitimacy of the method.
- Cost-benefit analysis arose from project management applications, whereas benefit-cost analysis is more often used in regulatory contexts.
- Cost-benefit analysis is more commonly used by British economists, benefit-cost analysis by American economists
- Among non-economists in the U.S. examining regulatory applications:
- Cost-benefit analysis is the term more likely to be used by persons who dislike it or object to its use.
- Benefit-cost analysis is the term more likely to be used by persons who like it or approve of its use.
