Foundations of Cost-Benefit Analysis

K N Ninan Donald Bren School of Environmental Science and Management University of California, Santa Barbara

Theoretical Foundations
CBA is a powerful tool that facilitates policy makers and decisions makers to make resource allocation and investment decisions. It is based on Neo Classical Welfare Economics. CBA is based on the notion of Human Preferences. Preferences are linked to Utility or Well-Being (or Human Welfare) Individual Preferences can be aggregated to derive Social Preference or a Social Welfare Function. Preferences are revealed in market places through decisions to spend or not to spend money.

Theoretical Foundations
Preferences could be gauged through the following two ways: Indirect Approach- Revealed Preference Approach (eg. travel cost method, hedonic pricing) Direct Approach- Stated Preference Approach (eg. contingent valuation method) (These are discussed under the subject Non Market Valuation) Preferences can be measured through Willingness to Pay (WTP) to Willingness to Accept (WTA) Compensation. Preferences can be aggregated through a common measuring rod Money. Efficiency Rule for Maximising Social Welfare or Human Well-Being. The issue of Who Gains and Who Loses Every Project/Policy has Gainers and Losers. Pareto Principle Kaldor-Hicks Compensation Test/Criterion (Potential Pareto Improvement Rule)

Theoretical Foundations
Critiques of CBA:
Since CBA is based on Neo Classical Welfare Economics the criticisms against neo classical welfare economics also apply to CBA. Important Critiques: Arrows Impossibility Theorem Scitovsky Paradox Boadway Paradox Bergson-Samuelson Social Welfare Function (Socially Consensus Function)

Microeconomic Theory and CBA-A Recap

Theory of (Consumer) Demand Welfare Economics which are the subject matter of Microeconomic Theory is useful in understanding the theoretical foundations of CBA. Theory of (Consumer) Demand: Cardinal Utility Theory Ordinal Utility Theory Indifference Curves Theory (based on Ordinalist Approach) Revealed Preference Theory (based on Ordinalist Approach)

Microeconomic Theory and CBA-A Recap

Traditional Theory of Consumer demand starts with examination of the behaviour of the consumer, since the market is assumed to be the summation of the demands of individual consumers. So we need to derive the demand curve for an individual consumer. Consumer (Individual) assumed to be: Rational Given his/her income and market prices of various commodities tries to maximise utility (satisfaction or well-being)-Axiom of Utility Maximisation Has Full Knowledge of all the Information relevant to his decision Has Full Knowledge of all the available commodities, their prices and his income.

Microeconomic Theory and CBA-A Recap

In order to maximise Utility (Satisfaction) the consumer needs to compare the different basket or combination of goods or commodities which he can buy with his income (or budget constraint) There are two approaches to the problem of comparison of utilities- Cardinalist Approach and the Ordinalist Approach Cardinalist Approach: postulates that Utility can be measured - by monetary units (by the amount of money a consumer is willing to sacrifice for another unit of a commodity). - or by subjective units called Utils.

Microeconomic Theory and CBA-A Recap

Theory of Consumer Demand: Cardinal Numbers- 1, 2, 3, 4, .n Ordinal Numbers 1st, 2nd, 3rd , 4th, nth (Ordered or Rankings)

Microeconomic Theory and CBA-A Recap

Theory of Consumer Demand (Cardinal Approach): Assumptions: 1. Rationality- Consumer is Rational. Aims at maximisation of his utility subject to the constraint imposed by his given income. 2. Cardinal Utility- Utility of each commodity is measurable. Utility a cardinal concept. 3. Constant Marginal Utility of Money- This assumption necessary if the monetary unit is used as the measure of utility. i.e. money being the measuring rod should be constant. 4. Diminishing Marginal Utility- Marginal Utility of a commodity diminishes as the consumer acquires larger (successive) quantities of the commodity- Axiom of Diminishing Marginal Utility.

Microeconomic Theory and CBA-A Recap

Critiques of the Cardinal Approach: 1.Assumption of Cardinal Utility is extremely doubtful. Satisfaction derived from various commodities cannot be measured objectively. Using Utils (an imaginary unit of satisfaction suggested by Walras) not satisfactory and highly subjective. 2. Assumption of Constant Utility of money unrealistic. As income increases the marginal utility of money changes. Thus money cannot be used as a measuring rod since its own utility changes. 3. Axiom of diminishing marginal utility has been established from introspection, it is a psychological law which must be taken for granted.

Microeconomic Theory and CBA-A Recap

Indifference Curve Theory (Ordinalist Approach): Assumptions: 1. Rationality: Consumer assumed to be rational- he aims at maximisation of his utility, given his income and market prices. It is assumed he has full knowledge of all relevant information. 2. Utility is Ordinal: It is taken as axiomatically true that the consumer can rank his preferences (order the various baskets of goods) according to the satisfaction of each basket. It suffices that he expresses his preferences for the various bundles of goods. It is not necessary to assume that utility is cardinally measurable. Only ordinal measurement is required. 3. Diminishing Marginal Rate of Substitution: Preferences are ranked in terms of indifference curves which are assumed to be convex to the origin. Indifference curve theory is based on the axiom of diminishing marginal rate of substitution.

Microeconomic Theory and CBA-A Recap

Indifference Curve Theory (Ordinalist Approach): Critique: 1. The main weakness of this theory is its axiomatic assumption of the existence and the convexity of the indifference curves. The theory does not establish either the existence or the shape of the indifference curves. It assumes that they exist and have the require shape of convexity. 2. It is questionable whether the consumer is able to order his preferences as precisely and rationally as theory implies. Also the preferences of the consumers change continuously under the influence of various factors so that any ordering of preferences even if possible should be considered as valid for the very short run. 3. This theory has retained most of the weaknesses of the Cardinalist approach with strong assumption of rationality and the concept of the marginal utility implicit in the definition of the marginal rate of substitution.

Microeconomic Theory and CBA-A Recap

Revealed Preference Theory (Ordinalist Approach) - Paul Samuelson: Assumptions: 1. Rationality: Consumer assumed to be rational- he prefers bundles of goods that include more quantities of the commodities. 2. Consistency: The consumer behaves consistently. That is if he chooses bundle A in a situation in which bundle B was also available to him he will not choose B in any other situation in which A is also available. i.e. if A > B, then B is not > A 3. Transitivity: If in any particular situation A > B and B > C, then A > C. 4. The Revealed Preference Axiom: The consumer by choosing a bundle of goods in any one budget situation reveals his preference for that particular bundle. The chosen bundle is revealed to be preferred among all other alternative bundles available under the given budget constraint. The chosen bundle maximises the utility of the consumer. The revealed preference theory establishes the law of demand directly on the basis of the revealed preference axiom without the use of indifference curves and their restrictive assumptions.

Marshallian Demand Curve

Marshallian demand curve states that as Price falls demand for a commodity increases and vice versa (True for Normal Goods). This is referred to as the Law of Demand or Marshallian Demand Curve. (due to law of diminishing marginal utility) Concept of Consumer Surplus introduced by Marshall- The difference between the amount a consumer is willing to pay to obtain a commodity (or benefit, say, an improvement in environmental quality) and what he actually pays to buy the commodity (or benefit) is called Consumer Surplus. It is the area under the demand curve to the left (shaded area in the figure in the next slide). Marshallian demand curve is referred to as Ordinary Demand Curve or Uncompensated Demand Curve (with standard market demand curve, money incomes are constant but welfare changes with moves along the curve. Because welfare changes, these demand curves are described as uncompensated) (Abelson, Project Appraisal and Valuation of the Environment, Macmillan, 1996, p.24 ) Under Marshallian demand curve while money income is held constant, welfare changes as prices rise or fall. If we wish to estimate the maximum that individuals are willing to pay for a proposed change, or to avoid an unwelcome change, we should estimate the demand curve that is consistent with constant welfare. In technical terms, we should employ compensated (Hicksian) demand curves that notionally hold welfare (real income) constant as prices rise or fall. (Abelson, p. 24)

Marshallian Demand Curve and Consumer Surplus

Source: Dixon et al: The Economics of Dryland Management, Earthscan, 1989, p.68

Demand and Supply Curves showing Consumer and Producer Surplus (Total Benefits to Society)

Source: Dixon et al: The Economics of Dryland Management, Earthscan, 1989, p.69

Indifference Map
Each higher indifference curve gives a higher level of satisfaction or utility ( Thus U3 > U2 > U1 )

Indifference Curve
Different combinations of two commodities, say, apples and oranges which give same level of satisfaction or utility to the consumer i.e. he is indifferent between these combinations.

Indifference Curve
Equilibrium of the consumer is attained at that point where the budget line or income is tangent with the highest possible indifference curve, in this case U2

Hicksian Demand Curve

Hicksian demand Curve referred to as (Income) Compensated Demand Curve. Under the Hicksian Demand Curve the size of the consumer surplus is smaller than in the case of the Marshallian Demand Curve. When prices fall or environmental quality increases a Hicksian demand curve produces a smaller benefit area than an uncompensated demand curve. Conversely, when prices rise or environmental quality falls a Hicksian demand curve produces a larger loss than a Marshallian demand curve. (Abelson, 1996, p.24) In the case of the Hicksian Demand Curve, the consumer adjusts his money income in such a way that welfare is held constant while the consumer selects the bundle of goods as prices changes that will keep him at the same level of welfare. In practice, when estimating project benefits most analysts ignore WTP differences between uncompensated and compensated demand curves for two main reason. Firstly, WTP differences are generally small. Secondly, it is much easier to work with observed or estimated market demand curves than with notional Hicksian demand curves. (Abelson, 1996, p.24 ) Note: A Price Effect can be split into two effects- an income effect and a substitution effect. As Price of a good falls, your real income goes up and you can buy more units of the good, or you can substitute and buy other goods with the rise in your real income.

Marshallian and Hicksian Demand Curves

Both Marshallian and Hicksian demand curves show quantity demanded as price changes, holding other things equal. The difference concerns the other things. An ordinary (Marshallian) demand curve is constructed by holding constant the consumers money income and allowing his level of welfare to change as the price changes. A compensated (Hicksian) demand curve is constructed by varying the consumers money income in such a way as to hold his level of welfare constant at all points on the curve. [Sugden & Williams 1978]

Compensating and Equivalent Variation

CV: CV measured with respect to the initial utility level. What money is required to push the consumer back onto their original indifference curve following a gain/loss? CV (gain): maximum amount of money that can be taken away from a household to leave it just as well off as it was before CV (loss): minimum amount of money that must be given to a household so as to leave it just as well off as it was before

Compensating and Equivalent Variation

EV: EV measured with respect to the new utility level. What money is required to shift the consumer onto the new indifference curve they would have been on after a gain/loss? EV (gain): the minimum amount of money that must be given to a household to make it as well of as it would be after. EV (loss): the maximum amount of money that must be taken away from a household to make it as well off as it would have been after Note : CS > CV EV > CS EV > CV Measurement of CV and EV Aggregation of CV and EV

Compensating Variation and Equivalent Variation

M1N1 is the budget line and C1 the preferred bundle of goods in some initial situation., while M2N2 is the budget line and C2 the chosen bundle in some subsequent situation, the compensating variation is the change in the individuals income necessary to move his budget line to the position indicated by the dashed line JK, which would just enable him to buy the bundle of goods at D1 yielding the same utility as the initial chosen bundle. This CV can be measured in terms of the quantities of either good in the diagram ( N2K of good A or M2J of good B) or in terms of money in which case it would be N2K/PA = M2J/PB where PA and PB are the prices of A & B respectively.

Instead of considering what sum of money would compensate for some change or the loss of some facility, we can estimate the adjustment to the consumers income that is equivalent in terms of its effects on the consumers utility, to the change. Thus if the consumer suffers the same loss of utility as in the move from C1 to C2 if relative prices remain unchanged and his income is reduced by M1R, leaving him on the dashed budget line RS, touching the indifference curve U1 at D2, M1R is then termed the equivalent variation in income, as it is the income change yielding the same utility change as the original price changes. EV need not be the same as CV

Peter Else & Peter Curwen: Principles of Microeconomics, Unwin Hyman, London &Boston

References for Microeconomics

A Koutsoyiannis (1982) Modern Microeconomics, Macmillan, 2nd section, Chapter 2 and 23. Peter Else and Peter Curwen ( ) Principles of Microeconomics, Unwin Hyman, London, Chapter 2, 3,and 5. Per-Olov Johnsson (1991) An Introduction to Modern Welfare Economics, Cambridge University Press, Cambridge. Chapters 3 and 4.

Theoretical Foundations of CBA

The theoretical foundations of CBA can be summarised as follows:-

Benefits are defined as increases in human well-being (utility). Benefit is what you are willing to pay (WTP) for securing a benefit (or welfare/wellbeing/utility); or willingness to accept (WTA) compensation for losing a benefit (There is a debate about whether to use WTP or WTA values while estimating project benefits and costs. WTP values generally preferred) WTP = Product Price + Consumer Surplus. Hence Market Prices are not a true indicator of Consumer Well-Being. The lower the price, the more important consumer surpluses are likely to be (Abelson, Project Appraisal and Valuation, Macmillan, 1996). Especially so in the case of Environmental Goods/Non-Market Goods where all benefits are consumer surpluses. Measurement of CS is, therefore, important for CBA especially for environmental goods. (Abelson, 1996).

Costs are defined as reductions in human well-being.

Theoretical Foundations of CBA

The theoretical foundations of CBA can be summarised as follows:-

A project or policy to qualify on cost-benefit grounds, its social benefits must exceed its social costs. Society is simply the sum of individuals. The geographical boundary for CBA is usually the nation but can readily be extended to wider limits.

Theoretical Foundations of CBA

The theoretical foundations of CBA can be summarised as follows: Aggregating benefits across different social groups or nations can involve summing willingness to pay/accept (WTP, WTA) regardless of the circumstances of the beneficiaries or losers, or it can involve giving higher weights to disadvantaged or low income groups. One rationale for this is that marginal utilities of income will vary, being higher for the low income group. Aggregating over time involves discounting. The rationale for discounting is given later. Discounted future benefits and costs are known as present values. Inflation can result in future benefits and costs appearing to be higher than is really the case. Inflation should be netted out to secure constant price estimates.

Theoretical Foundations of CBA

The theoretical foundations of CBA can be summarised as follows: The notions of WTP and WTA are firmly grounded in the theory of welfare economics and correspond to notions of compensating and equivalent variations. WTP and WTA should not, according to past theory, diverge very much. In practice they appear to diverge, often substantially, and with WTA > WTP. Hence the choice of WTP or WTA may be of importance when conducting CBA. There are numerous critiques of CBA. Perhaps some of the more important ones are: The extent to which CBA rests on robust theoretical foundations as portrayed by the Kaldor-Hicks compensation test. The fact that the underlying social welfare function in CBA is one of an arbitrarily large number of such functions on which consensus is unlikely to be achieved. The extent to which one can make an ethical case for letting individuals preferences be the (main) determining factor in guiding social decision rules.

Theoretical Foundations
Costs and Benefits will accrue over time and the general rule will be that future costs and benefits are weighted in such a way that a unit of benefit or cost in the future has a lower weight than the same unit of benefit or cost occurring now. This temporal weight is known as the Discount Factor and derived as follows: 1 DFt = ---------(1 + s)t where: DFt = Discount Factor or weight in Period t. s = Discount Rate. If projects and policies are being evaluated from societys viewpoint, s is a social discount rate.

Cost-Benefit Analysis Basic Decision Rule

The traditional decision rule for CBA is as follows:
Summation of the discounted benefits minus the discounted costs should be positive/greater than zero

{ Bi ,t (1 + s ) Ci ,t (1 + s ) } > 0
i ,t i ,t

(B
i ,t

i ,t

Ci ,t ).(1 + s ) > 0

Cost-Benefit Analysis Basic Decision Rule

Revised Formulation in terms of WTP/WTA

{ WTP i ,G (1 + s ) t WTP i ,Lt (1 + s ) t } > 0 t

i ,t i ,t

Where: i is the ith individual and t is time. In this formulation Benefits are measured by WTP to secure the benefits (G refers to gainers), and Costs are measured by WTP to avoid the cost (L refers to losers). If the losers from the project have legitimate property rights to what they lose, then WTP should be replaced by WTA, and the equation would read:

Cost-Benefit Analysis Basic Decision Rule

Revised Formulation in terms of WTP/WTA

{ WTPi ,G (1 + s ) t WTAiLt (1 + s ) t } > 0 t ,

i ,t i ,t

The notion of WTP and WTA can be extended to include WTP to avoid a cost and WTA compensation to forego a benefit. The difference, then is that losses are measured by WTA and not by WTP.WTA can differ significantly from WTP. In the two equations WTP and WTA are discounted so that when summed over time the resulting magnitude is known as Present Value (PV). A Present Value is simply the sum of all discounted Future Values. The above equation can also be written as PV (WTP) PV (WTA) > 0

Cost-Benefit Analysis Aggregation Rules

In the two equations WTP and WTA are summed up across individuals in accordance with aggregation rule which defines society as the sum of all individuals. Typically CBA studies work with national boundaries so that society is equated with the sum of all individuals in a nation state. But there could cases where boundaries may extend beyond national boundaries e.g global or transboundary pollutants, such as acid rain, emissions of greenhouse gases ,etc. For e.g. Acid Rain- Those who suffer damage caused by emissions from one country may be in a neighbouring or different country. Hence damage caused to another country would be relevant to CBA in the emitting country. a) Moral judgement that others suffering should count. b) Legal obligations arising from transboundary pollution agreements.

Cost-Benefit Analysis Aggregation Rules

Hence a CBA might appear in a two part form: First Part: Show the costs of acid rain abatement for the country in question, and the benefits to that country of the abatement. Second Part: Show the same costs but also the benefits would be shown as those accruing both to the country in question and all other countries that benefit from pollution abatement. Greenhouse Gas Emissions: The world may be the boundary in this case and greenhouse gas emissions cause damage worldwide. Same principles (moral and legal) apply to justify including these world-wide damages in a CBA conducted for one emitting country.

Cost-Benefit Analysis Aggregation Rules

The issue of Who Counts in CBA is known as issue of Standing. Even if the issue of standing has been agreed upon, other ethical principles might be evoked to determine the aggregation rule applicable to geographical boundaries. If the well-being of people in country B matters as much to country A as the well-being of As own people, as measured by money, then the aggregation rule would be one of adding up benefits and costs regardless of to whom they accrue. In this case US$ 1 gain/loss to B matters as much as US$ 1 of gain/loss to A. A more utilitarian rule would take account of income or wealth differences. For e.g. if the inhabitants of B are poor and those of A are rich, allowance might be made for the likelihood that US$ 1 of gain/loss to a poor person will have higher utility than US$ 1 of gain/loss to a rich person. This involves taking note of variations in the marginal utility of income which has lead to use of equity weighting in CBA so as to take note of distributional impacts of a project or policies.

Cost-Benefit Analysis Aggregation Rules

The two equations also aggregate across time. But what is aggregated is not the absolute values but the discounted values of WTP or WTA (or Benefits and Costs). This is because costs and benefits are spread across years and we need to make them into a comparable series by adjusting for inflation.This is done through the process of converting the cash flow of benefits and costs occurring over a period of time (which is in current prices i.e. not adjusted for inflation) into a comparable series by converting the time series data into constant prices i.e. by adjusting for inflation using a price deflator The next table illustrates how benefits and costs are distributed over time. The assumed discount rate is 5%.The final row shows the discounted net benefits. When these are summed it is seen that net benefits is positive (105.5) while costs are 95.2 i.e. the Net Present Value is Positive. Usually future costs and benefits are discounted to a base year (in this case Year 1). The practice is to usually reduce it to the year when initial costs are/were incurred.

Cost-Benefit Analysis Aggregation Rules

Year 1 Year 2 Year 3 Year 4

Benefit

80

60

40

Cost

-100

20

20

20

Net benefit Discount factor*

-100 0.952

60 0.907

40 0.864

20 0.823

Discounted net benefits

-95.2

54.4

34.6

16.5

Assumes a discount rate of 5% Source: Pearce et al (2006) Cost-Benefit Analysis and the Environment, OECD, Paris.

Cost-Benefit Analysis Inflation

CBA- The need and how to adjust for Inflation for undertaking a CBA. For undertaking a CBA the cash flow of benefits and costs need to be adjusted for inflation. Usually the value of benefits and costs are valued at the price prevailing during the period of the appraisal. The next table illustrates how the WTP/WTA values expressed in current prices i.e.the prices prevailing in the year they occur are converted to constant prices or net out inflation. In the example a 3 inflation rate is assumed. So to undertake a CBA you need to: * Convert the cash flow of benefits and costs into constant Prices * Thereafter you discount these values to estimate the present value of benefits and costs

Cost-Benefit Analysis Inflation

Year 1 Year 2 Year 3 Year 4

Net benefit in current prices

-103

63.6

43.7

22.5

Netting out inflation at 3% p.a. = net benefit in constant year 0 prices Discount factor*

-100

60.0

40.0

20.0

0.952

0.907

0.864

0.823

Discounted net benefits

-95.2

54.4

34.6

16.5

Pearce et al (2006) Cost-Benefit Analysis and the Environment, OECD, Paris, p.44

Benefits, Costs, WTP and WTA

The explanation of this BC equation in terms of WTP and WTA needs a little more elaboration. A gain in utility or well-being (say, an improvement in environmental quality) can be measured by the maximum amount of goods or services or income that he/she is willing to give up or forego. A loss in well-being (say, a reduction in environmental quality) can be measured by the amount of money that the individual is willing to accept as compensation in order to accept the change Consider an individual in an initial state of well-being U0 he/she achieves with a money income Y0 and an Environmental Quality level of E0 Uo (Yo Eo)

Benefits, Costs, WTP and WTA

Suppose that there is proposal to improve Environmental Quality from Eo to E1 . This improvement would increase the individuals wellbeing to U1 U1 (Yo E1) We need to know by how much the well-being of this individual is increased by this improvement in environmental quality ie U1 U0 Since utility cannot be directly measured we seek an indirect measure, ie the maximum amount of income the individual would be willing to pay (WTP) for the change. The individual is hypothesised to be considering two combinations of income and environmental quality that both yield the same level of well-being (U0): one in which his income is reduced and environmental quality is increased, and a second in which his income is not reduced and environmental quality is not increased, ie: U0 (Yo WTP, E1) = U0 (Y0, E0)

Benefits, Costs, WTP and WTA

The individual adjusts WTP to the point at which these two combinations of income and environmental quality yield equal well-being. At that point WTP is defined as the monetary value of the change in well-being, U1 U0, resulting in the increase in environmental quality from E0 to E1. This WTP is termed the individuals Compensating Variation, and it is measured relative to the initial level of well-being, U0. U0 (Yo WTP, E1) = U0 (Y0, E0) An alternative is to ask how much an individual would be willing to accept (WTA) in terms of additional income to forego the improvement in environmental quality and still have the same level of well-being as if environmental quality had been increased. The individual is then considering the combinations of income and environmental quality that yield an equal level of well-being (U1). U1 (Yo WTA, E0) = U1 (Y0, E1)

Benefits, Costs, WTP and WTA

where WTA is a monetary measure of the value to the individual of the change in well-being U1 U0 resulting from the improvement in environmental quality. This is termed the Equivalent Variation. It is measured relative to the level of well-being after the change, U1. Here the monetary measure of the value of the change in well-being could be infinite if no amount could compensate the individual for not experiencing the environmental improvement. Analogous measures for policy changes that result in losses in well-being can be derived. In this case the Compensating Variation is measured by WTA, and the Equivalent Variation is measured by WTP. Suppose the move from E0 to E1 results in a reduction in the individuals well-being. Then, the Compensating Variation is the amount of money the individual would be willing to accept as compensation to let the change occur and still leave him or her as well off as before the change

Benefits, Costs, WTP and WTA

U0 (Y0 + WTA, E1) = U0 (Y0, E0) The required compensation could again, in principle, be infinite if there was no way that money could fully substitute for the loss in environmental quality. The equivalent variation is the amount of money the individual would be willing to pay to avoid the change: U1 (Y0 - WTP, E0) = U0 (Y0, E1) In this case the equivalent variation measure of the value to the individual of the change in well-being resulting from a deterioration in environmental quality from E0 to E1 is finite and limited by the individuals income. The following table summarises the various measures of welfare gains and losses.

Compensating and Equivalent Variation Measures

Compensating variation = Amount of Y that can be taken from an individual after a change such that he/she is as well off as they were before the change Increase in human welfare U0(Y0-WTP,E1) = U0 (Y0,E0) Equivalent variation = If a change does not occur, the amount of Y that would have to be given to the individual to make him/her as well off as if the change did take place U1(Y0-WTA,E1) = U1 (Y0,E1)

Decrease in human welfare

U0(Y0+WTA,E1) = U0 (Y0,E0)

U1(Y0-WTP,E0) = U1 (Y0,E1)

Pareto Criterion
Pareto ( 1848, 1923): in his Cours d Economie Politique (1896) argues that the only objective test of whether or not social improvement had been brought about by a change in the existing state was if some people were made better off and no one was made worse off- Pareto Condition or Criterion. The strict Pareto Principle - whereby a policy is good if at least some people actually gain and no one actually loses was clearly stultifying. Virtually all real life context involves gainers and losers. The Pareto Principle was considered to be sterile because it said that a policy was a good policy if and only if no-one suffered a welfare loss and at least one person experienced a gain. (referred to win-win situations). It is hard to find win-win situations; someone always loses in one way or other. The difficulties with the Pareto Criterion led to the formulation of the Kaldor-Hicks Compensation Test.

Kaldor-Hicks Compensation Test

Kaldor-Hicks Compensation Principle (or Test) (Also referred to as Potential Pareto Improvement Rule): The impracticality and problems associated with the Pareto Criterion (which stated that a project or policy was good if and only if no-one suffered a welfare loss and at least one person experienced a gain) led to the formulation of the idea of hypothetical compensation as a practical rule for deciding on policies and projects in these real life contexts. All that is required is that gainers can compensate losers to achieve a Potential Pareto Improvement Compensation Principle or Test. This establishes the prima facie rule that benefits (gains in human well-being) should exceed costs (losses in human well-being) for policies and projects to be sanctioned. It says that so long as gainers can compensate losers and still have some net gains left over, the policy is a good policy. The Kaldor-Hicks test actually mimics the Pareto Rule but with two important provisions compensation need not actually be paid, and interpersonal comparisons of welfare are not being made because one can think of the compensation as some form of bargain in which the losers decides how much he/she needs for the original level of well-being to be unchanged.

Critiques of CBA
Since CBA is based on Neo Classical Welfare Economics, the criticisms leveled against Neo Classical Welfare Economics also apply to CBA. Arrows Impossibility Theorem: In his Social Choice and Individual Values establishes there exists no way to decide whether something is a social improvement or not, or we insist that social rankings are based on individual preferences and on certain reasonable criteria. But CBA is a procedure for aggregating individuals preferences so that CBA must fail the Arrows Impossibility Theorem. There is no reasonable way of going from individuals preferences to a social ordering of different states Arrows Theorem related to individuals preferences being expressed in an Ordinal fashion. That is, preferences are capable of being ordered but the distance between them could not be measured.

Critiques of CBA
For eg an Ordinal ranking of states x, y, and z could be : U (x) > U (y) > U (z) where U simply means Utility or Well-Being. With Ordinal ranking no meaning could be attached to the distance between, say, U (x) U (y) The Intensity of Preferences cannot be measured For eg if Anne states that she obtains 10 utils (units of satisfaction) from consumption of an apple and Mike says he gets 5 utils from consumption of an apple we cannot state that Anne obtains double the level of satisfaction (utils) than Mike from consumption of an apple. In contrast Cardinal orderings would enable values to be attached to the distances for purposes of comparison. For eg U (x) U (y) = 9, and U (y) U (z) = 3 We can say that the former is 3 times the latter.

Critiques of CBA
Problem of Inter-Personal Comparisons of Utility: To avoid above problem the various intervals between U (x), U (y), etc should mean the same thing for all individuals. For eg it would imply that U1 (x) U2 (y) > U2 (x) U2 (y) where 1 and 2 are different people, otherwise preferences cannot be aggregated.But if Cardinal Utility and Inter-Personal Comparisons both apply then CBA would appear to be valid since preferences can be aggregated. The view that interpersonal comparisons were themselves impossible had become widely accepted with the publication of Lionel Robbins famous essay in 1938.

Critiques of CBA
Problem of Inter-Personal Comparisons of Utility: Interpersonal comparisons become essential with the hypothetical (Kaldor-Hicks) Compensation Test.If compensation is actually paid no problem arises. But if it is not actually paid then it is necessary to know if the gainers really could compensate the losers, i.e. the relative size of the gains and losses must be known, which means comparing utilities across different people. If Interpersonal Comparisons of Utility cannot be made then you cant aggregate preferences (to arrive at the social preference)- If so then the Arrow Theorem applies and all non-dictatorial mechanisms for aggregating individual preferences are imperfect in the sense of permitting inconsistent social orderings. If Interpersonal Comparisons of Utility can be done then CBA applies and the Arrows Theorem does not apply.

Critiques of CBA
Scitovsky Paradox: Scitovsky (1941) showed the potential contradiction in the hypthothetical compensation principle. Since a change making some better off and some worse off would change the distribution of income it was possible for those who lost to (hypothetically) compensate those who gained to return to the original situation. In other words the question arises as`to what happens to income distribution once a policy or project is implemented. In theory it could change in such a way that the policy originally sanctioned by the potential compensation principle could also be negated by the same principle i.e. benefits exceed costs for the policy, but the move back to the original pre-policy state could also be sanctioned by CBA. This is referred to as the Scitovsky Paradox.

Critiques of CBA
Bergson-Samuelson Social Welfare Function: A Bergson (1938) suggested that the policy showing the highest net benefits may not, in fact, be the best one to undertake. One of the ways out of this problem could be to assume a social welfare function a rule that declared how aggregate welfare would vary with the set of all individuals welfare. The problem is of finding a social welfare function that might be regarded as a socially consensus function there are many possible functions and no practical prospect of deciding which one to use. Paul Samuelson (1942) argued that consumer's surplus had no practical validity because one could not assume that the marginal utility of income was constant.The marginal utility of a dollar is higher for the poorer classes as compared to the rich.

Critiques of CBA
Other critiques: Boadway Paradox (1974): Boadway raises another problem that policies my change income distributions and hence relative prices- which in turn will impact on CBA. CBAs underlying value judgement that individual (human) preferences count. Those who believe in Rights-based Approach find CBA unacceptable.Critics believe that other species have intrinsic rights which are not amenable to analysis using human preferences unless humans can be judged to take those rights into account when expressing their own preferences. Others believe that individuals are poorly informed about the environment and its importance as a life-support asset. Guiding policy in these circumstances based on human preferences could risk other social goals, even human survival itself. (Public Trust doctrine used by US Courts to override CBA in several court rulings)

Critiques of CBA
Other critiques:
Belief in Rights is perhaps an example of what has been called endogenous preferences, preferences that are formed by the social context of decision making ,by how others believe, by institutions and social conditioning (Gowdy, 2004) Moral CBA: do moral considerations enter into CBA? A debatable issue ? What motivates human preferences ? Moral notions may also determine human behaviour and it is not clear that such motivations cannot be encompassed in the CBA framework. Other criticisms relate to use of WTP as a measure of preference, discounting, , distribution and equity, sustainability, etc.

Social Welfare Functions

The general form of a social welfare function is W = W ( u1, u2, .,um) Where u1, u2, .,um are the utilities of the m individuals in the economy.Such a function is an entirely artificial construct.It is not possible to measure W for any given specification of the function W(.) because its arguments, the utility of individuals, are not directly measurable without reference to some constraint. Three Specific Social Welfare Functions: The Utilitarian ( or Benthamite) Welfare Function states that everyone's utility should count equally regardless of their level of utility (reflects utilitarian ethic). The Rawlsian Welfare Function (named after John Rawls-Theory of Justice 1974) states that the welfare of society is equal to that of its least well-off member. The Weighted Utilitarian Welfare Function uses weights to reflect the importance of each individual to overall social welfare.The usual interpretation is that changes in the utility of poor people carry more weight in determining a change in social welfare than do changes in the utility of wealthy people.

References
David Pearce, Giles Atkinson, Susana Mourata (2006) Cost-Benefit Analysis and the Environment- Recent Developments, OECD, Paris, Chapter 2. Peter Abelson (1996) Project Appraisal and Valuation of the Environment- General Principles and Six Case Studies in Developing Countries, Macmillan, London. Chapter 1.