Tuesday, December 18, 2007

Cost benefit analysis and decisionmaking

An excellent two paragraphs from the Environmental Economics blog:

Jim Kahn (I hope I have the link right) on benefit-cost analysis (via the RESECON listserv):

The most important thing to remember is that Cost-benefit analysis (with its associated discounting process) is not a decision-making tool. It is an information organizing tool. It organizes information with respect to one decision-making criterion, economic efficiency. There are many other criteria such as inter-temporal equity, cross-sectional equity, environmental stewardship, etc that are equally important in the decision-making process.

It should also be noted that cost-benefit analysis can fail in the organization of data about economic efficiency. My view is that one should never pay any attention to any cost-benefit analysis that chooses one value for key variables such as the discount rate, the rate of growth of demand for energy, the rate of growth of population, etc. A truly useful cost-benefit analysis runs the numbers with different values for these key variables and then looks at how the bottom line is sensitive to the choice of values of these key variables. This sensitivity analysis is what permits us to wisely choose policy, choosing a policy that might not be the best under a particular set of circumstances, but one that we will not regret given the actual state of the world at which we arrive.

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