The Economist explains

Why doing a cost-benefit analysis is harder than it looks

By C.W.

WHEN it comes to assessing the viability of a large project, governments are increasingly likely to commission a cost-benefit analysis (CBA). The aim is to provide an impartial, evidence-based judgment of the costs and benefits of a particular policy or project, without regard to its political ramifications. The British government is particularly keen on CBAs: having pioneered their use in the 1960s it has recently relied on them to make the case for HS2, a controversial high-speed rail link between London, Birmingham and Manchester, and to justify a cull of badgers in the countryside. In theory, putting together a CBA is simple: you simply tot up the costs in one column and the benefits in another. But the reality is rather more complex. With large amounts of money at stake and projects that can last for decades, economists have to use a number of wonkish techniques, some of which are controversial, to come up with a decent CBA. How do they do it?

The simplest and most important concept is a dull economic term: “consumer surplus”. This is the difference between what you are willing to pay for something and what you end up paying. If you’re willing to spend £1 on an apple, but get it for 40 pence, your consumer surplus is 60 pence. Consumer surplus is important because big projects like railways are often not sustainable from a purely commercial perspective. In the case of HS2 one estimate puts the expected revenue from fares at £15 billion, but the overall costs at £25.5 billion. But that is potentially a narrow way at looking at the benefits of such a project. Governments can also look at what they are saving citizens. Consider the case of someone who is used to paying £100 to get from Manchester to London. If HS2 is built, they could pay £40. The commercial benefit of the project is a mere £40; but the CBA will take into account the £60 worth of consumer surplus as well (because that sum is, in effect, unlocked to be spent on other things). Big infrastructural projects often make economic sense only when consumer surplus is taken into account.

To make costs and benefits fully comparable, further economic trickery is needed. Adjusting for inflation is an obvious first step. Then you must convert the calculated costs and benefits at various times to values at a single point in time, so that they can be compared. Economists refer to this as “net present value”. Wonks also need to think about how money invested in a project might be better spent. The government could just choose to shove the money into a bank account and gather the interest, or invest instead in another project that offers higher returns. Economists call this idea the “opportunity cost of capital”. There are no golden rules for choosing the appropriate rate—sometimes called the “discount rate”, though it often corresponds to what people could get by buying government bonds. In an analysis of the badger cull the British government went for 3.5%. The higher the discount rate, the smaller the future benefits will seem. Some worry that those opposed to big investment projects deliberately exaggerate discount rates.


As CBA has become integral to large projects, the limitations to its methodology have come under greater scrutiny. CBAs struggle to put monetary values on things like environmental quality. Crafty economists try to get around this problem by calculating “willingness to pay”: working out how much money someone would spend to clean the air or purify water. In addition, no two CBAs are alike, so it is hard to compare different studies. And sometimes the assumptions can be heroic, to say the least. An early analysis of HS2 claimed that people did not do any work on trains, thereby increasing the benefit of shorter journey times. This idea was subsequently scrapped and the focus became more on the economic benefits to the north. But despite being controversial CBAs are popular. Governments will rarely approve a big project without first submitting their proposal for wonkish scrutiny.

Dig deeper:
One city now carries the hope of high-speed rail boosters (March 2014)
The revised case for HS2 still rests on some dodgy assumptions (Nov 2013)
All of us do intuitive cost-benefit analyses every day (Sep 2009)

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