8. Appendix
8.1 Background to economic analysis
Marginal analysis, comparing the incremental gains against incremental costs of an action, is fundamental to the economic approach to efficient resource allocation. Provided outputs and inputs are correctly valued, the most efficient outcome will be obtained by allocating inputs to the point where the marginal cost just equals the marginal return (or benefit) of the output obtained.
While such an approach has ready application in decisions concerning private enterprises with clearly defined activities, where market prices of inputs and outputs can be taken as the correct marginal values, there are difficulties in applying it to more complex issues in the public sphere. Marginal effects are blurred where outputs are joint products of input packages, which can be adjusted lonely in lumpy rather than continuous increments. Also, where there are different technologies with different cost structures for achieving the same outputs, equating marginal costs to marginal benefits may not result in a unique solution (Sinner, 1991).
Under such conditions the allocation decision is better guided by examining the total net gain from one option over others. In relation to environmental policy aimed at resource decisions, the prime criterion for selecting policies on the grounds of efficiency is to maximise net benefits from policy, i.e.:
Maxmise NB = TB –TC
where TB, TC are total benefits and total costs for each respective policy option.
This is the approach adopted by cost-benefit analysis, whose basic formulation is:
NPV = å (Bt – Ct)/(1 + r) t
where NPV is the Net Present Value of the project/option
Bt, Ct are costs and benefits occurring in each year over the life time of the project
r is a discount rate applied to future benefits and costs
and t is each successive year over the project’s life.
Cost benefit analysis procedure compares benefits and costs from the project for each year in its life, applies a discount factor appropriate to that year, and sum the results to obtain the Net Benefits of the project over its lifetime in Present Value terms. An environmentally sustainable project would be considered worthwhile in efficiency terms if:
- It yields a positive net benefit (NPV > 1); and
- Its return is higher than that available from using the funds in any other way (NPVSC > NPVO)
A distinctive feature of cost benefit analysis is that it need not be confined to the effects felt by any particular agency or body – effects on third parities can be explicitly allowed for (as, for instance, effects on individual vehicles are routinely factored into roading appraisals) so that the result corresponds to an economic cost for the community rather than a financial cost to any one section within it. Within this broad, however, it is possible to structure the analysis to distinguish different sectoral effects within the community, which may serve as a guide to distributing costs across the community.
Another characteristic of CBA is that, by aggregating benefits across the community, its decision criterion inherently presumes the desirability of coercive change, i.e., if the sum of gains exceeds the sum of costs the project is deemed to be welfare enhancing, irrespective of the distribution of gains across the community, or of the unwillingness of some members to contribute to it. This presumption of coercion is not universally adhered to within mainstream economics, and it can be viewed as less desirable than market exchanges, which are usually entered into voluntarily. Conversely, institutional commentators (e.g. Bradsen 1992) regard the voluntary nature of past conservation policies as their major weakness. The varying opinions about the coercive presumption are less of a problem if CBA is used as an analytic rather than as a prescriptive tool, aimed at determining the opportunity cost of inaction rather than whether to act.
Contact for Enquiries
Rural Affairs Coordinator
Sector Performance Policy
MAF Policy
Ministry of Agriculture and Forestry
PO Box 2526
Wellington
NEW ZEALAND
Phone: +64 4 894 0675
Fax: +64 4 4 894 0745
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