Cambridge International as and a level Economics Ebook

Shadow price:
 
one that is applied where there is no 
recognised market price available.
KEY TERM
Scarcity and choice: 
Cost–benefit analysis is a well-used 
technique for dealing with the fundamental economic 
problem in situations where the market mechanism is an 
inappropriate way of allocating scarce resources. It forms 
the basis for decision making by governments, especially 
in the context of public goods. 
KEY CONCEPT LINK
TOP TIP
CBA is best viewed as a guide to decision making; the 
final decision invariably will depend on funds that are 
available in relation to competing alternatives.
The framework of cost–benefit analysis
Whatever the problem under investigation, there are four 
main stages in the development of a cost–benefi t analysis. 
Th
ese are shown in 
Figure 6.8
.
Th
e fi rst stage is to identify all of the relevant costs and 
benefi ts arising out of any particular project. Th
is involves 
establishing what are the private costs, the private benefi ts, 
the external costs and the external benefi ts. On the surface 
this may seem a relatively simple task. In reality, and with 
a little more thought, it is not so easy. Th
ere are particular 
problems when it comes to identifying external costs and 
benefi ts. Th
ese are oft en controversial, not easy to defi ne 
in a discrete way and have the added diffi
culty that it is not 
always possible to draw the line in terms of a physical or 
geographical cut-off . Th
e spillover eff ects of a new retail 
development or rail route, for example, are wide-reaching 
and aff ect people and communities beyond the immediate 
vicinity of the proposed development.
Th
e second stage involves putting a monetary value 
on the various costs and benefi ts. Th
is is relatively 
straightforward where market prices are available. For 
example, in the case of a new retail development, a 
monetary value can be put on the jobs created or the 
increased profi ts arising from the development. For other 
variables, however, a monetary value must be attributed 
for costs and benefi ts where no market prices are available. 
Th
is particular measurement diffi
culty has occupied 
economists for thousands of hours over the years. It 
has also been a very controversial matter in situations 
where cost–benefi t analysis has come under close public 
scrutiny. A particularly good example of this is the issue of 
valuation of time, especially travel time savings. Another 
relevant example is how to put a monetary value on the 
cost of accidents, particularly where serious injuries or a 
loss of life is involved.
Th
e third stage applies in situations where projects have 
longer-term implications that stretch well into the future. 
Here, economists have to employ statistical forecasting 
techniques, sometimes of a very crude nature, to estimate 
costs and benefi ts over many years. Th
is particularly applies 
to proposed projects where massive capital expenditure is 
involved.
Th
e fi nal stage is where the results of the earlier stages 
are drawn together so that the outcome can be presented 
in a clear manner in order to aid decision making. Th
e 
important principle here is that if the value of benefi ts 
exceeds the value of the costs, then the particular project 
Identification
of all relevant costs 
and benefits
Putting a 
monetary
value 
on all relevant
costs and benefits
Forecasting 
future
costs and benefits
(where appropriate)
Decision making 
– the
interpretation of the
results from CBA