Used and Useful

by | Nov 14, 2013 | Uncategorized

The Right Tool For The Right Job – Cheap, Responsive, and Realistic

I recently wrote a rather cynical post (Decisions, Decisions) about how economists and cost-benefit analysis (CBA) were useful, but too expensive to be used enough in infrastructure projects. Often what is built is not what was analyzed by the economists and their fancy decision support tools. Small decisions have a large cumulative impact in big infrastructure projects and so plans diverge from design which again is different from the as-built project.

CBA can be made more useful by being:

  • cheaper;
  • responsive to the concerns of those affected by the project; and,
  • by being realistic in its accuracy.

Let’s start with the objections to using CBA to make the case (justification or feasibility) or to provide a basis for comparing projects or alternatives within a project.

CBA – A Luxury Good with B/C < 1?

The first is cost, as I discussed in the last post. CBA is expensive to do because economists are well-paid and they like to do custom studies and tend to re-invent the CBA wheel (and data) each time the analysis is done. When the cost of a CBA is north of $50,000 I wonder whether the benefit to cost ratio (B/C) for an infrastructure CBA is greater than one (that is the benefits of the study are greater than its costs and hence a good idea)?

There really is no reason for infrastructure projects to shy away from using CBA repeatedly for all decisions in a project. The CBA methodology is standardized nine-step process (ten if you include the consulting economist’s advice to rinse and repeat – apologies for the cynicism – again).

Also much of the data to be used is codified by governments.

The Optimum but Not the Optimum Optimorum

Good CBA identifies choices that makes society better off. So what could possibly be wrong with using it?

Well, implementing the alternative with the lowest cost-benefit ratio can improve overall efficiency1 but while CBA produces an efficient outcome but it may not be an equitable outcome.

NIMBY-ism is a powerful force these days. Siting any infrastructure project is difficult because someone (or something) will likely be worse off even is as a whole we are better off. There is always the ability for the winners to compensate the losers and so CBA provides the basis for deal structuring.

One useful addition to CBA is Multiple Account Cost Benefit Analysis that effectively does a mini-CBA for each stakeholder group (users or beneficiaries of the project, government or taxpayers, and non-users living near by for example) or account (e.g. the environment or the local economy).

This allows the project sponsor to understand each group’s perspective and think about how to structure a deal so that benefits and costs are equitably distributed.

Multiple account CBA makes CBA more relevant in helping to understand objections and work towards a deal.

Are You Sure?

Producers and consumers of CBA know that it has limitations. “An analyst using CBA should recognize that perfect evaluation of all present and future costs and benefits is difficult, and while CBA can offer a well-educated estimate of the best alternative, perfection in terms of economic efficiency and social welfare are not guaranteed.” 2

Risk associated with costs of a project is regularly handled by cost estimators using probability theory. Benefits can be handled the same way. Uncertainty in the CBA inputs “can be evaluated using a sensitivity analysis, which shows how results respond to parameter changes. Alternatively a more formal risk analysis can be undertaken using Monte Carlo simulations.”3

Prediction is a mug’s game. That is why I became a micro- rather than a macro-economist. Even if the CBA is done well, no-one will believe it if it is reduced to one number. There are too many things that can go wrong. The people who request CBAs know this the economists who produce them don’t.

To effectively communicate the benefits of an infrastructure project one needs to know the risk of not achieving the projected budget, schedule, and the benefits.

Cost-Benefit Analysis Can Be Made Relevant Again

If economists can make CBA affordable, use it to inform deal balancing and incorporate risk then they can turn it over to the Marketing Department:

  • CBA – Cheaper! And, now More Tasty Perspectives, and Improved with Risk Adjusted Values!

1CBA identifies projects that can increase Pareto efficiency. Pareto efficiency is where it is impossible to make any one individual better off without making at least one individual worse off.

2http://en.wikipedia.org/wiki/Cost-benefit_analysis#Theory

3http://en.wikipedia.org/wiki/Cost-benefit_analysis#Risk_and_uncertainty

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