James Hammitt is Professor of Economics and Decision Sciences at Harvard School of Public Health. He is the director of the Harvard Center for Risk Analysis and fellow of the Society for Risk Analysis. His research concerns
the development and application of quantitative methods—including benefit-cost, decision and risk analysis—to health and environmental policy.
He holds a PhD in Public Policy from Harvard University.
Benefit-cost analysis (BCA) is a form of applied welfare analysis that is often used to help choose government policies, especially for environmental, health, and safety regulation and investment in transportation. It is often required in the United States, and is becoming more common in France and the European Union.
What is the goal of BCA? What question does it answer? These questions are critical for understanding how BCA results should be interpreted and how BCA should be conducted.
There are at least two possible bases for justifying BCA, positive and normative. The positive basis derives from the text-book description of BCA as a method that identifies policy changes that satisfy the Kaldor-Hicks compensation test. The test asks whether those who benefit from a policy change could compensate those who are harmed so that everyone would judge himself better off with the policy change and compensation payments than without. This justification leaves unanswered the normative question of whether passing the Kaldor-Hicks compensation test is either a necessary or sufficient condition for the policy change to improve social wellbeing.
The normative basis asserts that BCA is a method to identify policy changes that constitute social improvements, where improvement must be defined in some way that is external to BCA. Several normative justifications can be offered. One is derived from a form of utilitarianism in which the objective is to maximize the sum of well-being in the society and it is assumed that well-being can be measured using standard economic concepts such as compensating and equivalent variation. This justification leads naturally to the suggestion that the monetary values of benefits and costs should be weighted depending on whether they fall on rich or poor, given the intuition that marginal utility declines with wealth.
Other normative justifications are motivated by pragmatism. One such claim is that BCA is a practical method that approximates the result of an ideal but impractical measure of social welfare. Another is that BCA helps promote consistent decision making by avoiding random errors and protecting against cognitive mistakes that can arise when a decision maker tries to evaluate a policy change by holistic judgment. A third claim is that, if policies that maximize net benefits are routinely chosen, everyone will be better off in the long run because those who benefit and those who are harmed will tend to vary across decisions. Obviously, the strength of these pragmatic claims depends on the alternatives with which BCA is compared.
Conflict between positive and normative justifications? Conventional BCA relies on standard economic assumptions about human behavior. The most important of these is that people act to maximize their own well-being (subject to the constraints they face). Yet behavioral-economic research provides evidence that people often behave in ways that do not maximize well-being as it is represented by utility functions like those in conventional economic models. Choices seem to be jointly determined by a combination of “real interests” and other factors such as analytic errors, myopic impulses, inattention, passivity, and misinformation.
Do these behavioral deviations from the predictions of standard economic models reflect decision-making errors or are standard models oversimplified, ignoring important and legitimate concerns? Surely, both answers are correct: some deviations are due to error, and models are, by design, oversimplified. A more useful question is which of the deviations between behavior and economic models reflect errors that individuals would wish to correct, were they aware of them, and which reflect inadequacies of standard models in describing normatively appropriate behavior?
Differences between behavior and standard models drive a wedge between positive and normative justifications for BCA. If people always behave in accordance with standard economic theory, then any policy that satisfies the Kaldor-Hicks compensation test will expand the “social pie” and the central question about BCA would be how to balance efficiency (as measured by aggregate net benefits) against distribution of well-being within society and other concerns. If not, then policies combined with compensation payments that are predicted to yield Pareto improvements may not deliver; affected individuals may not perceive themselves to be better off.
How should policy makers and analysts respond when confronted with public preferences that depart from the normative preferences embodied in economic models? Paul Portney posed this question in his 1992 parable, “Trouble in Happyville”: Imagine you are the Director of Environmental Protection for the town of Happyville. There is a naturally occurring contaminant in the town’s drinking water that all of the residents believe is carcinogenic and may account for the towns’ above-average cancer rate. Each resident is willing to pay $1,000 to cover the cost of treatment that will eliminate the contaminant. You have consulted with the world’s leading risk analysts and each has reported that, while one can never be sure, each would stake her professional reputation on the conclusion that this contaminant is benign. You have repeatedly and skillfully communicated these judgments to the citizenry, but each of them still prefers to spend the money to treat the water. What should you do? If you call for the water to be treated, you are knowingly denying each resident the other benefits he could achieve with $1,000 but each resident will believe himself to be better off. If you reject the treatment option, you are knowingly imposing a policy that each resident believes is contrary to his well-being.
Implications for Benefit-Cost Analysis If BCA is conceived as a positive exercise, with the goal of determining whether policy consequences satisfy the condition that those who benefit could theoretically compensate those who are harmed, then the objective is to measure benefits and harms exactly as they are perceived by the affected population. When these perceptions conflict with normative models, the normative models are irrelevant. Under this interpretation, analysts should measure individual preferences as accurately as possible. Predicting policy consequences and measuring individual perceptions are scientific questions that are, in principle, susceptible to empirical testing. In addition, this approach respects individual autonomy (consumer sovereignty).
If BCA is conceived as a positive exercise, its significance for policy is uncertain. While a practice of choosing policies that satisfy the Kaldor-Hicks compensation test allows for the possibility that everyone in the population will gain, there is no guarantee that such an objective will be achieved and the possibility that other social objectives, such as fair distribution of outcomes or equality of opportunity may be compromised.
If BCA is conceived as a normative exercise, then the normative basis must be specified. As the choice of normative basis is a political rather than a scientific question, it seems appropriate for the choice to be made by the relevant political decision makers, though the prospects that they will provide a sufficiently precise statement for analysts to follow seem limited. When using a normative basis, the analyst must determine which parameter values in the BCA are consistent with the corresponding normative model. This may require adjusting empirical estimates to correct for behavioral biases; it is not clear how such adjustments are made. The normative approach assumes the analyst is a better judge of individuals’ well-being than the individuals themselves, and opens her to charges of elitism or paternalism. Many of the questions involved in conducting BCA under a normative justification are not scientific but philosophical and not susceptible to empirical testing, which places in the analyst in more of an advocacy than a scientific role. Nevertheless, benefit-cost analysis that rests on an accepted normative basis is by definition more useful for policy guidance than one that simply predicts if the policy passes the Kaldor-Hicks compensation test.
The choice of justification is part of a larger question about the role of representative government: should the government provide the citizenry what the citizenry believes it wants at the moment, much as a direct democracy (or a politician who slavishly follows public-opinion polls) might do, or should it provide leadership, directing the citizenry in a direction it does not yet know (and might never agree) is in its real interest? The tension is nicely encapsulated by the views of two eminent statesmen. Thomas Jefferson (1820): “I know of no safe repository of the ultimate powers of society but the people themselves; and if we think them not enlightened enough to exercise their control with a wholesome discretion, the remedy is not to take it from them, but to inform their discretion by education.” Edmund Burke (1774): “Your representative owes you, not only his industry, but his judgment; and he betrays, instead of serving you, if he sacrifices it to your opinion.”
Professor Hammitt wrote this article in June 2012, however, due to mistakes on the side
of The TSEconomist it was not published in the last issue. We wish to apologize to Professor Hammitt for this inconvenience.