This is the first in a series of four blogs featuring key excerpts from the writings of our founder and past president, Richard Zerbe. His insights shaped the foundation of our association and remain relevant to today’s challenges. We hope these selections offer valuable perspectives to all members.
It is useful to date the major changes in Cost-Benefit Analysis (CBA) from the publication of the 1979 work of Kahneman and Tversky (1979) and the subsequent creation of the Society for Benefit-Cost Analysis (SBCA) - which occurred at a 2007 meeting arranged by the Evans School at the University of Washington at which we proposed to form a Society for Benefit Cost Analysis - with a concomitant Journal. In using the Benefit-Cost Analysis (BCA) terminology we thought to distinguish BCA from its CBA roots in engineering. This distinguishment aimed to provide a more economic flavoring to the name and to practice. I suggest BCA can be usefully seen as a further development or evolution of CBA. Table 1 shows the differences.
Table 1: Differences in CBA and BCA
|
CBA |
BCA |
|
The KH criteria |
Drops KH for a full Pareto test based on Edgeworth’s consent justification. See Zerbe, Richard O, 2020, “The Consent Justification for Benefit Cost Analysis”, J. of Benefit-Cost Analysis vol. 11 (2) pp. 319-340 |
|
No well-defined reference point |
Has well defined reference points established by law or norms based on work by Kahneman and Tversky. |
|
The treatment of moral sentiments |
Treats morals as other goods for which there is a WTP. See e.g. Zerbe, Richard O. (2009). “Ethical Benefit Cost Analysis as Art and Science: Ten Rules for Benefit-Cost Analysis,” University of Pennsylvania Journal of Law and Social Change 12(1), 73-106 Zerbe, Richard O), Yoram Bauman and Aaron Finkle (2006). “An Aggregate Measure for Benefit-Cost Analysis,” Ecological Economics, 58(3), 2006, 449-461. |
|
Issues of standing |
Uses law and norms to determine standing See Zerbe, Richard O. (Winter 1991). “Comment: Does Benefit Cost Analysis Stand Alone? Rights and Standing,” Journal of Policy Analysis and Management, 10(1), 96-105. |
|
Issues with compensation |
Recognizes that compensation can satisfy a BCA test. |
|
Little acknowledgement of the role of law |
Recognizes a strong reliance on law in setting reference points and in determining standing. See Zerbe, Richard O. (Fall 2007). “The Legal Foundation of Cost-Benefit Analysis,” Charleston Law Review, 2(1), 93-184. |
|
Little or no recognition of behavioral Economics |
Recognizes the importance of behavioral economics. |
|
Widely criticized |
Obviates most criticism. See Zerbe, Richard O. (Fall 2007). “The Legal Foundation of Cost-Benefit Analysis,” Charleston Law Review, 2(1), 93-184. |
|
No resolution of discount Rate Issues |
No resolution of discount rate issue. |
|
The possibility of Scitovsky reversals exists |
No such possibility exists with BCA as it drops the Kaldor-Hicks potential compensation test (PCT). It should be acknowledged, however, that even under the potential compensation test, reversal probability is quite low. See Just, Richard, Andrew Schmitz, Zerbe, Richard O. (2013) “Scitovsky Reversals with Normal Goods”, Journal of Benefit-Cost Analysis, pp.411-413 |
BCA Defined
BCA is defined here to contain the following foundational assumptions and aspirations, as compared to CBA.- The use of Net Present Value (NPV) using the Coefficient of Variation (CV) is a reasonable summary measure for evaluating a project.
- The recognition of a Consent Justification (Edgeworth, 1881, Zerbe 2020) for the use of BCA.
- When projects have small income and substitution effects, the differences between Willingness to Pay (WTP) and Willingness to Accept (WTA) compensation are smaller and are reasonably ignored. Otherwise, the gain-loss discrepancy needs to be taken into account.
- BCA considers all goods for which there is a WTP as economic goods. This includes the realization of ethical or moral sentiments as goods for which there is a WTP or WTA. This is part of the issue of standing in BCA (Whittington and McCrae, 1986, 1990; Zerbe 1991, 2002).
- BCA recognizes both social preferences, Social Rate of Time Preference (SRTP) and the Opportunity Cost of Capital (OCC), in discounting.
- For benefit estimation, the most rational approach is to follow Viscusi and Gayer (2016) who suggest that “we adopt the default position of respecting consumer sovereignty under the presumption that fully informed people are better able to make decisions that bear on their own well-being than are others.”
- The recognition of the use of law in defining ownership, rights, and standing to be counted, and thus connects BCA with law and the treatment of values arising from illegal behavior and illegal goods.
- BCA uses WTP as gains from a legal reference point and uses WTA as losses from the legal reference point, recognizing that losses count more than equivalent gains. In doing this BCA recognizes the reference point, as developed by Kahneman and Tversky, and the compensating and equivalent variations developed by Hicks.
- BCA notes the recognition of a broader range of goods, such as existence values and equity preferences, as goods for which there exists a willingness to pay, WTP.
- The discount rate recognizes both capital opportunity costs and time preferences.