Tuesday, 15 May 2018

Cost-benefit analysis and cost-effectiveness analysis are different

In yesterday's New Zealand Herald, Jamie McKay wrote about an interview with Environment Minister David Parker. This bit caught my eye (emphasis mine):
DP: Huh! The industry has been consulted for over a decade here! In terms of cost-benefit you don't actually do an analysis on whether you should have clean rivers, that's a value judgement, and the vast majority of New Zealanders think we should have rivers clean enough to swim in. What you use cost-benefit analysis for is to look at what is the most cost effective way of getting there.
No, that's NOT what you use cost-benefit analysis for. At least, it is not helpful to conflate cost-benefit analysis with cost-effectiveness analysis in this way.

Cost-effectiveness analysis evaluates the cost per unit of benefits for some option, where the benefits need not be measured in dollars (e.g. a reduction in nutrients in a stream). Cost-effectiveness analysis is useful when there is more than one way of obtaining benefits, because it tells you that whichever option achieves a unit of benefits at the lowest total cost is the more cost-effective approach.

Cost-benefit analysis is related, but different. It compares the costs of some activity with its benefits, where both the costs and benefits are measured in dollars (so that they are comparable). The outcome of a cost-benefit analysis is technically a measure of cost-effectiveness - it is a measure of the ratio of benefits to costs (in other words, it measures the value of benefits for each dollar of cost, which is the inverse of cost-effectiveness). If this ratio is greater than one, then the benefits of the activity are greater than the costs. If this ratio is less than one, then the benefits are less than the costs. Simple. Cost-benefit analysis is useful if you want to determine whether or not to undertake some action, or to choose between mutually exclusive alternatives.

Cost-benefit analysis for a single option (e.g. for cleaning up a stream) doesn't tell you what is cost-effective, because that is not its purpose. You need to be comparing multiple options to evaluate cost-effectiveness. In the case of clean streams, there probably are several options for clean-up to choose from. Of course, if you conducted multiple cost-benefit analyses for the different options, then you could argue that the option with the highest ratio of benefits to costs is most cost-effective. But cost-benefit analysis would likely be overkill for this purpose.

Cost-effectiveness analysis is easier to conduct than cost-benefit analysis, because for cost-effectiveness analysis you don't need to measure the value of the benefits (in dollars), which can be difficult as it requires non-market valuations of the benefits. Cost-benefit analysis will only be necessary if you have multiple benefits and you want to know the combined benefit (since converting everything to dollar values is a handy way to combine benefits in a single measure). But that is probably not the case for streams, where you can measure the benefits in terms of something like reduced nutrient loads, and converting the benefits to dollar terms would only add an additional source of error to the analysis.

Cost-effectiveness analysis is much more flexible than cost-benefit analysis if, as Parker implies, you've already made the decision to have clean rivers. If cleaning up streams is your sole goal (e.g. based on a measure of a single nutrient load or an index of several nutrient loads), then cost-effectiveness analysis is most likely what you would use to determine the most cost-effective way of getting there, NOT cost-benefit analysis.

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