Cost Benefit Analysis and Freedom
Sanjeev Sabhlok
Preliminary Draft25March 2014
This is very preliminary.
Happy to receive input at
Contents
1.Structure of good regulation and public policy
1.1Utilitarianism, neo-classical economics, and liberty (Extract from DOF)
1.2Want good policy? Do a cost-benefit test first, then test for freedom
2.Theory of cost benefit analysis
2.1Key benefits of CBA
2.1.1CBA leads to efficient outcomes for society
2.1.2CBA overcomes limitations in decision-making: Reducing biases, cognitive errors, and mental shortcuts
2.2Common objections to the CBA approach
2.2.1Criticism: Not feasible to aggregate preferences
2.2.2Criticism: Not possible to value everything
2.2.3Criticism: Issues of equity ignored
2.3Brief history of CBA techniques in regulation
2.3.1Project evaluation
2.3.2Regulatory analysis
2.4Some advanced techniques for assessing costs and benefits
2.4.1Valuing tangibles using market data
2.4.2Valuing intangibles
2.4.2.1Market-based techniques
2.4.2.2Revealed preference techniques
2.4.2.3Stated preference/survey techniques
2.5Some examples of intangible costs and benefits
2.5.1Value of prevented fatality (statistical value of life)
2.5.2Environmental costs and benefits
2.6Common errors in conducting a CBA
2.6.1Forecasting and valuation errors
2.6.2Omission errors
2.6.3Double counting
2.6.4Exclusion of important stakeholders
2.7Conclusion
2.8References and suggested reading
1
1.Structure of good regulation and public policy
The ten questions that should be asked of any regulation/ policy are provided here (Sone Ki Chidiya policy framework).
This structure is scientific and requires a cost benefit test, plus test of freedom, before any government intervention.
1.1Utilitarianism, neo-classical economics, and liberty (Extract from DOF)
I pointed out in the first chapter that the entire discipline of economics is based, basically on four simple assumptions about human nature. These mathematically expressed assumptions generate the standard utility function which is then amenable to mathematical deduction. Using this model, economists test behaviour through utility maximisation equations subject to a relevant budget constraint. This method leads to many extremely useful conclusions.
So what is the relationship between maximising our freedoms – subject to accountability – and maximising utility subject to a budget constraint? I believe these two are closely related so long as all key externalities are taken into account. We use our freedom to maximise what (we believe) is good for us, and to minimise what we believe is evil or vile (using Hobbes’s three-fold terminology). Only free people can choose among the full range of options available to maximise utility. In other words, utility maximisation can’t work properly without freedom.
The utility maximising model must ensure that we internalise the costs of the damage we cause, for the theory of freedom (and justice) insists onaccountability. The concept of freedom is a far higher principle. The utility maximising model can accommodate accountabilities through, for instance, markets for pollution or court imposed penalties for harm. The standard economic theory can therefore be used for the most part, but with caution in the few matters discussed below.
In the first instance we should note that utility maximisation works for individuals, not aggregates. Aggregation of utility across the society, the basic bread and butter of ‘welfare economics’, doesn’t work very well. But it is theoretically impossible to aggregate the preferences of all individuals, or to compare utilities. This approach is therefore fundamentally flawed.
According to Bentham, ‘it is the greatest happiness of the greatest number that is the measure of right and wrong’[1]. Thus, a ‘utilitarian’ aims to maximise the total utility of a society. By assuming that everyone has the same utility function, a ‘social welfare function’ – which merges everyone’s identity[2] – can be mathematically created. The utility maximising model can accommodate a host of political theories, including the Rawlsian collectivist maximin (i.e. difference) principle, by making appropriate assumptions. We must guard against its misuse; the mathematics must be rigorously controlled by philosophy.
This idea, of lumping all individuals together, can destroy individual freedom if we do not exercise great caution. Attempts to maximise ‘social’ utility seem to invariably lead to arguments for redistribution of wealth. However, agovernment must only facilitate the maximisation of our freedom subject to accountability. Everything else, including whether we are happy or not, is something we determine, independently. Benthamite paternalism is all pervasive but the typical start of the slippery slope towards statism.
For instance, Claude-Adrien Helvétius (1715-1771), the founder of utilitarianism (Bentham was its most prominent proponent) believed that the policy maker should educate people so they are better equipped to increase their happiness and reduce pain. The laws would then provide incentives to people to do the ‘right’ thing. This is an unnecessarily statist and paternalistic approach, and suggests that policy makers are ‘smart’ and people are stupid. We hear strong echoes of in modern behavioural economics, for instance that the default option for a (public) financial saving scheme should be conservative. Such conception can easily infringe on our liberty and this approach must be closely interrogated.
Utilitarian approaches can also end up denying freedom when they become ‘inconsistent even with Pareto optimality – perhaps the mildest utility-based condition and the most widely used welfare criterion in economics.’[3] We must therefore consider trade-offs between strict utilitarianism and freedom. Freedom must receive unambiguous precedence.
The technique of social cost-benefit analysis (CBA) suffers from the defect of aggregation. When economists compare costs and benefits (say, of regulation) across an entire society, they are generally often indifferent about the individuals on whom these costs are imposed, so long as net benefits are positive. In some cases those who cause harm do pay up, but in others regulations become a channel for re-distribution and destroy the liberal social contract (for coercive redistribution by the state is theft).
Some utilitarians have sought to conduct a cost-benefit analysis of freedom itself. Such analysis ‘can lead one to argue against slavery on the grounds that the advantages to the slaveholders do not counterbalance the disadvantages to the slave and to society at large’[4]. Even the thought of such a possibility is totally abhorrent. Freedom is beyond CBA – a higher, non-negotiable value. Utilitarian CBA must necessarily be subordinated to the overarching demands of life and liberty. Having said this, CBA does act as a check on drastically bad policy by forcing the disclosure of the policy maker’s assumptions, and by (at least notionally) treating everyone equally in the calculations.
1.2Want good policy? Do a cost-benefit test first, then test for freedom
InBFNI've cautioned against the blind use of economic (or cost benefit) analysis, thus:
While endorsing most of the standard literature of economics and economic reforms, I would like to suggest a few words of caution:
- Our future is too important to be left to economists. We must never let economists monopolize the thinking that we need to put in as concerned citizens. The literature of economics should be used to supplement our holistic thinking; not as a primary source of policy ideas.
- Economists are driven primarily by the goal of economicefficiency. They do not base their advice purely on the principles of freedom. They are therefore likely to propose interventions by governments on grounds of market failure, information failure, information asymmetry, ‘equity’ and so on.We should soundly reject such advice.We need to back off from any intervention by the government unless it is proven without doubt that such intervention willimprove our freedomsincluding our accountability. Let us follow the imperatives of freedom and we won’t go wrong.
And in theOnline notes to BFN(these will, I hope, one day be re-combined with the main book, according to the original design):
If conclusive evidence cannot be adduced to prove beyond doubt that the government can, on balance, deliver better outcomes than citizens acting on their own behalf, then that activity will revert back to the citizens.It is preferable that citizens solve a Problem imperfectly in complete freedom, than for them to pay a government to do it equally or more imperfectly at much greater cost.
Basically, efficiency is about a cost-benefit test. I have not denied the value of a cost-benefit test inBFN, butcautioned against giving it more value than it deserves.
The freedom test
Without first qualifying the hurdle of a cost-benefit test, however, we can't even come close to assessing the second (and key question) does this policy pass the test of freedom? There are areas of government policy that must be off-limits REGARDLESS OF COSTS AND BENEFITS. That is what I've written about inBFNthrough the three-tier classification of the roles for government:
FIRST ORDER: A good government needs to deliver high quality outputs in at least three ‘first-order’ core areas, of defence, police and justice. These functions must be carried out outstandingly well and, if necessary, to the detriment of all other functions. If funds run short, a government can always provide incentives to citizens to take up relatively secondary things like infrastructure through a range of innovative ways by transferring property rights over roads, airports, or railways.
SECOND ORDER: After performing these first-order core functions outstandingly well, a government must focus on providing infrastructure and equality of opportunity. Appropriate funds need to be deployed to deliver second-order core functions well. Given space constraints, I do not discuss infrastructure provision here. All I note is that where goods are excludable, i.e. wherever boundaries can be drawn around an infrastructure and therefore user-pays ticketing is feasible, such infrastructure will be sold in a systematic manner to the private sector. Where partial ownership or property can be given to the private sector, such as through toll-based highways or other public–private partnerships, that option will be explored. Finally, where it is not feasible to privatize infrastructure because of non-excludability, the government will directly provide the service wherever possible, outsourcing it and acting as an auditor rather than manager.
THIRD ORDER:There are some non-core functions that a government can also perform, if funds so permit. (I only gave the example of environmental sustainability inBFN,but a few others, e.g. support for the preservation of "heritage" might come in this category).
TheFreedom Team of Indiahas, after nearly three years of debate, adapted this approach to categorisation of public policy (I encourage you to consider FTI's draft approach, which is quite good).
The diagram below summarises this:
This is revolutionary stuff!
But note that this way of thinking is quite revolutionary! For instance,in India, NO policy is ever determined through a cost benefit test (leave alone a test of freedom). I'll leave you here with an extract from a recent conversation on FB with Harsh Vora:
Harsh Vora:Legalizing drugs is indeed a delicate issue. Here, Friedman makes fairly strong points in its support by explaining the 'negative' effects of banning drugs. I guess the question is whether the costs outweigh the benefits! {Reference:this youtube video}
Sanjeev Sabhlok:The idea that cost/benefit analysis should be undertaken for public policy is totally revolutionary. Most moralists will not accept it. It is also difficult (in a moral sense) to quantify the value of the loss of innocents' lives. Moralists don't see both sides of the picture: only one (i.e. that taking drugs is wrong). I suspect on a pure economic cost benefit test, legalisation of drugs (with good regulatory frameworks) will significantly overwhelm the policy of prohibition.
Cost-benefit analysis is a utilitarian (a branch of classical liberalism) concept that gives all costs and all benefits equal weight, which is a weakness in its design (for after all, the rich man cares less for a loss of Rs.100 than a poor man). It also does not factor in the loss of freedom. However, in the absence of other techniques, it is the best available method, and if used carefully, can get us towards good policy. I think I briefly wrote about it in BFN. In India there is NO concept of cost-benefit analysis but only whims of policy makers (or moralistic preachers who claim to tell us what we should do).
2.Theory of cost benefit analysis
This section outlines some of the more technical aspects of CBA, an analytical tool commonly used to assist policy officers in making decisions about appropriate policies.
These notes provide an overview of the theory and context about the concept and methodology of the CBA. These notes also discuss commonly raised concerns and questions.
In addition, these notes outline techniques for preparing a CBA. It should be noted that using some of these techniques can require a level of analysis that may be disproportionate to the requirements of the proportionality principle that should apply to all good policy.
Given the vast number of issues involved, however, these notes only outline the key issues. References and suggestions for further reading are provided to assist in forming a more detailed understanding.
2.1Key benefits of CBA
The CBA has significant advantages over less formal methods of assessing the impacts of policy. It is useful because it:
(a)considers community-wide impacts of a policy option/decision;
(b)allows the consideration of a range of policy options, and benefits and costs to be compared over time;
(c)determines which policy maximises net benefits to the community, thus achieving socially efficient outcomes;
(d)can show the costs and benefits accruing to different groups within the community; and
(e)utilises objective methods of analysis to reduce biases and cognitive errors
These benefits can be more broadly categorised as either relating to enhanced efficiency (ad) or as a way of overcoming limitations in decision-making (e). These are discussed further below.
2.1.1CBA leads to efficient outcomes for society
The CBA enables policy makers to pick those regulatory options from amongst a bundle of options that provide the greatest net benefit to society. It avoids over-spending on one particular policy area at the expense of others, by allowing comparisons of costs and benefits across a range of regulatory options. Thus, it is desirable that the costs imposed on the community for saving one life in a particular sphere (e.g. traffic safety) are comparable to costs imposed for saving one life in another sphere (e.g. workplace safety). This can assist in the optimal allocation of a society’s resources across alternative uses. An example:
The cost-benefit principle says we should install a guard rail on a dangerous stretch of mountain road if the dollar cost of doing so is less than the implicit dollar value of the injuries, deaths, and property damage thus prevented. Many critics respond that placing a dollar value on human life and suffering is morally illegitimate. The apparent implication is that we should install the guard rail no matter how much it costs or no matter how little it affects the risk of death and injury. Given that we live in a world of scarcity, however, this position is difficult to defend. After all, money spent on a guardrail could be used to purchase other things we value, including things that enhance health and safety in other domains. Since we have only so much to spend, why should we install a guardrail if the same money spent on, say, better weather forecasting that would prevent even more deaths and injuries? (Frank: 914).
2.1.2CBA overcomes limitations in decision-making: Reducing biases, cognitive errors, and mental shortcuts
CBA helps to reduce a range of cognitive errors that prevent objective analysis of evidence. As Sunstein notes,
Poor judgments, by individuals and societies, can result from certain heuristics, from informational and reputational cascades, from thinking processes in which benefits are “on screen” but costs are not, from ignoring systemic effects of one-shot interventions, from seeing cases in isolation, and from intense emotional reactions. Cost-benefit analysis serves as a corrective to these cognitive problems. … Cost-benefit analysis should be understood as a method for putting “on screen” important social facts that might otherwise escape private and public attention. (Sunstein: 1059-60)
Cognitive psychology and behavioural economics tell us about the biases and shortcuts that humans take. A systematic CBA can assist help minimise most of these.
- Availability heuristic: We tend to think that events are more probable if we can recall a particular case or incidence of its occurrence. More publicised events therefore appear to us to have occurred more frequently even though the data may indicate otherwise. This is because often significant but less perceptible risks are given greater attention to risks that are easily perceived but infrequent. The standardisation of all risks is crucial in helping to arrive at a good policy.
- Informational (social) cascade: Group think is another typical bias. In this case, someone in a position of authority is able to capture the public dialogue, by virtue of their position. This can set off a social cascade as “hundreds, thousands, or millions of people come to accept a certain belief simply because of what they think other people believe” (Sunstein: 1066). This is the phenomenon underpinning fashions and fads, which occur in all spheres, including policy,
- Reputational cascade: “If many people are alarmed about some risk, you may not voice your doubts about whether the alarm is merited, simply in order not to seem obtuse, cruel, or indifferent. And if many people believe that a certain risk is trivial, you may not disagree through words or deeds, lest you appear cowardly or confused. The result of these forces can be cascade effects, mediated by the availability heuristic. Such effects can produce a public demand for regulation even though the relevant risks are trivial” (Sunstein: 1067).
- Loss aversion: Because we are loss averse, “any newly introduced risk, or any aggravation of existing risks, is seen as a serious problem, even if the accompanying benefits … are considerable” (Sunstein: 1068).The alarmist bias isclosely related to loss aversion.”[R]isk-related concerns are often based on feelings rather than judgments. Thus risk- related objections can be a product not so much of thinking as of intense emotions, often produced by extremely vivid images of what might go wrong” (Sunstein: 1070). It appears that the “mere existence of discussions of new risks can aggravate concern, even when the discussions take the form of assurances that the risk level is relatively low”.
- Difficulty in assessing systematic effects. “[M]ost [people] … do not see the complex, system-wide effects of particular interventions” (Sunstein, p.1069). It thus takes considerable expertise and thorough analysis to understand the system-wide effects, including unintended consequences, of regulatory interventions.
- Distortions by taking problems in isolation: A well designedCBA “operates as a built-in corrective to some of the distortions that come from taking problems in isolation” (Sunstein, p.1072). That is because “people's answers to questions taken in isolation are very different from their answer to questions when they are asked to engage in cross-category comparisons” (Sunstein, p.1071).
2.2Common objections to the CBA approach
2.2.1Criticism: Not feasible to aggregate preferences
Jeremy Bentham suggested in 1776 that ‘it is the greatest happiness of the greatest number that is the measure of right and wrong’.[5] The net benefit criterion, being a corollary of utilitarian principle, underpins the CBA and requires a comparison of society-wide economic and other benefits with costs.