Benefit Cost Analysis Theory

Many public programs are promoted on the premise that all citizens will benefit. If investment in a public project makes at least one individual better off and no one worse off, then the project is described as Pareto satisfactory, after the noted Italian economist Vilfredo Pareto. When all such projects have been undertaken, the situation is deemed Pareto optimal. In practice, most public expenditures increase the welfare of some individuals while reducing the welfare of others. As a result, it is often regarded as too stringent to require that all public works fit the Pareto satisfactory criterion. Instead, it is often required that they meet the criteria of a potential Pareto improvement, where there are positive net benefits. In other words, a government program or project is deemed attractive under the potential Pareto improvement criterion when beneficiaries could fully compensate losers and still receive positive net benefit.

The potential Pareto improvement criterion provides the rationale for benefit-cost analysis: Public programs and projects are desirable from a social standpoint so long as benefits exceed costs. Whether beneficiaries actually compensate losers is immaterial. The allocation of benefits and costs among various individuals is a separate equity issue. Much like the distribution of tax burdens, the allocation of costs and benefits from public programs and projects is thought to depend upon popular notions of fairness, rather than upon efficiency considerations.

In theory, any public good or service should be supplied up to the amount that equates marginal social costs and marginal social benefits. This principle is similar to the profit-maximizing standard that output should increase to the point where marginal revenue equals marginal cost. For purposes of public-sector analysis, social benefits play the role of revenue and social costs play the role of production expenditures. As in the process of profit maximization, benefit-cost analysis presumes that all relevant pluses and minuses associated with public programs and projects can be measured in present-day dollar terms.

The marginal social costs of any good or service equal the marginal cost of production plus any marginal external costs, such as pollution (discussed in Chapter 13), that are not directly borne by producers or their customers. Production costs borne by producers and their customers represent private economic costs; external costs include the value of foregone marginal private costs

Production expenses borne by producers and their customers marginal social benefits

Added private and public advantages marginal private benefits

Value enjoyed by those who directly pay for any good or service marginal external benefits

Value enjoyed by non-purchasers and not reflected in market prices

alternative goods and services. In the absence of marginal external costs, marginal private costs and marginal social costs are equal at all levels of output. Marginal social benefits are the sum of marginal private benefits plus marginal external benefits. Marginal private benefits are enjoyed by those who directly pay for any good or service; marginal external benefits are enjoyed by purchasers and nonpurchasers alike and are not reflected in market prices. When no externalities are present, marginal social benefits equal marginal private benefits.

The optimal allocation of social resources is shown in Figure 16.2 where the marginal social cost curve intersects the marginal social benefit curve at Q*. Marginal social cost and marginal social benefit curves show that for all levels of output greater than Q*, additional social costs exceed additional social benefits. For output levels less than Q*, the marginal net benefit to society is positive. For output levels greater than Q*, the marginal net benefit to society is negative.

The optimal production of public-sector goods and services follows the same rules as optimal private-sector production. For example, consider the simplified case of two government programs or public-sector investment projects, project X and project Y. Optimal relative amounts of X and Y are made available to consumers so long as the ratio of marginal social benefits equals the ratio of marginal social costs for both projects:

Marginal Social Benefitx Marginal Social Benefit^

Marginal Social Costx Marginal Social CostY

When the ratio of marginal social benefits is equal to the ratio of marginal social costs across all government programs and public-sector investment projects, each respective program

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