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Social Cost-Benefit Analysis November 24, 2010

Posted by Chetan Chitre in Costs, Managerial Economics.
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Introduction –

Costs can be simply understood as compensation to be paid for use or damage caused to some property. Benefits on the other hand are monetary values attached to advantages gained.

The first step while taking a decision whether to set-up a project or not, is to conduct a detailed Cost-Benefit Analysis. Be it an infrastructure projects undertaken by the government like roads, dams, ports, airports, etc., or projects undertaken by private sector such as setting up a manufacturing unit – every project brings certain benefit to a set of people. At the same time there is a cost associated with setting up the project. It is advisable to set-up a given project only if the sum of benefits arising out of the project is greater than the sum of costs incurred on that project. Such a study, which compares the benefits and costs associated with a project is called a Cost-Benefit Analysis.

Social Cost-Benefit Analysis –

While, one is evaluating a project, quite often, the C-B Analysis that is conducted in Private Cost Benefit Analysis or what is more commonly called as Feasibility Study – i.e. only Costs and Benefits accruing to private investors or owners of the project are taken into consideration. So the Capital invested in the project is seen as cost while the monetary profits arising from the project are seen as benefits. The evaluation is then reduced to comparing whether the profits (i.e. Benefits) are sufficient to justify the capital investment (i.e. Costs)

However, Social C-B Analysis takes a different approach. Apart from considering the private costs and benefits arising out of a project, Social C-B Analysis also takes into consideration the costs and benefits arising out of a project to society at large.

Example –

If one is evaluating an industrial project, the private C-B Analysis will take into consideration following costs and benefits –

Costs (C) Benefits (B)
Capital Expenses in setting the project Profits to shareholders
Raw Material  
Labour  
Interest  
Taxes  

If C < B then the project would be considered good for investment.

On the other hand while evaluating the Social C-B the list would include the following –

Costs (C) Benefits (B)
Change of use of land – if any Employment generation
De-forestation – if any Taxes paid to government
Loss of livelihood for people whose land was acquired Development of ancillary activities around the industry – eg. restaurants, shops, etc.
Displacement of people – if any Infrastructure development – if any
Damage to environment  
Use of natural resources – water, minerals, etc.  

The above tables illustrate the difference in approach while conducting a Social C-B Analysis.

Steps in Social Cost-Benefit Analysis –

As key decision like whether to invest or not to invest in the project depend on the Cost-Benefit (C-B) analysis, it has to be conducted with utmost care. The following precautions are necessary while conducting the C-B Analysis –

(a)    Identifying items of Costs and Benefits – Identifying items of costs and benefits while conducting a private C-B study is relatively easy. However, in Social C-B study, this poses a major challenge. This is because both, the Social Costs and Social Benefits may be spread over large range. The person conducting the study has to consider both temporal and spatial dimensions while identifying the costs and benefits.
For example – A factory is letting-out untreated toxic effluents in the near-by river. The river may be carrying the effluents a few hundred kilometers away where farmers use the water for food crops. The toxic substances enter the crop and are consumed by the consumer who is perhaps living in some other part of the world. If this consumer suffers any health hazard because of the toxic substances found in the food, the factory should be held responsible for it and should be made liable to pay damages. However, the geographical distance between the factory and the eventual site of the damage is so large that it would become extremely difficult to identify the damage and pay the costs.
Similarly, a dam that is constructed is going to benefit the population living in the vicinity for around 50-100 years. In such cases it would become difficult today to know who will enjoy the benefit 50 years hence.
Such issues associated with Social C-B analysis makes it difficult to know who, when and where gets benefited (or pays the cost).

(b)   Valuation of Costs and Benefits – Another important challenge in conducting a Social C-B analysis is valuation of the cost or benefit. The C-B study computes all costs and benefits in terms of monetary values. However, it is not always possible to arrive at a monetary value to all costs or benefits. Some examples where computing a monetary value of costs and benefits would be a problem can be given as under –
(i) Hole in the Ozone layer caused by industrial pollution – the damage caused in this case would be so large that it is impossible to compute the value of compensation that will have to be paid. Or the cost of repair (if such a repair was possible) is unknown.
(ii) Water in the river – Quite often natural resources such as water, minerals, trees, etc. are valued at extraction costs and not at production cost, which is in itself wrong.
(iii) A person who was otherwise unemployed now gets employment in the factory and can now afford to give education to his children.

(c)    Method of Compensation – Especially in the matter of payment of Social cost, the issue of appropriate method of paying the compensation poses a challenge. For example – A farmer lost his livelihood as his land was acquired for a project. The question is what would be the right method of compensating such a farmer – will it be a specific sum of money, will it be another piece of land in the vicinity, will it be a job for a family member at the project site? There could be pros and cons about each of these methods. Deciding a proper method for compensation poses a challenge for managers.

(d)   Allocation of Costs – A Social cost or benefit quite often arises out of collective action of a number of players. For example, all motor vehicles used in the city are collectively responsible for the air and noise pollution in the city. It would be wrong to hold any single vehicle-user responsible. Similarly, mere setting-up an industry in a backward area does not result in development of the region. It has to be accompanied by roads, schools, water-supply, housing facilities, etc. A large number of factors thus contribute to the economic development of the area and it would be wrong for the factory to claim that the entire benefit to the area has been on the account of the factory alone.
Especially in the context of cost, then the question arises as to how the total cost is to be allocated among different players. So in the context of the above example of air-pollution in the city due to motor-vehicles – in case a few people suffer from respiratory problems on account of pollution, how should their medical bills be recovered between different vehicle owners in the city? Should the recovery from each vehicle owner be on the basis of distance travelled in a month, should it be on the basis of fuel efficiency of each vehicle, should it be on the basis of emission efficiency? Each of these criteria, if used for recovery will have its pros and cons.

(e)   Who Gets Benefits and Who Pays Costs – This is another important issue to be considered in Social C-B study. While considering Private C-B the answer to this question is clear – i.e. we examine the C-B accruing to the shareholder. However, the same is not the case when one analyses the Social C-B. Here we are analyzing C-B accruing to the society at large. However, society is not a homogenous entity. It comprises of different groups of people whose interest may at times run in opposite directions. All these groups may not be affected by a given project in the same manner. For example, the Mumbai-Pune Expressway is a great benefit to the people travelling between Mumbai and Pune. However, it caused great hardships to people who land was acquired for the project. It then requires a comparison of the Costs (or hardships) suffered by one set of people against the benefits accruing to another set of people. Such a comparison has its own set of complications.

(f)     Time Value of Money – The benefits of the projects accrue over the entire life of the project. The costs on the other hand are to be incurred in the first few years. In cases where the project is to be implemented in phases, the costs are also spread over a larger time frame. While conducting the study in the present time frame, one will have to discount the value cost and the benefit and find out their Present Values. This may be difficult as one would be required to know the total life span of the project, the interest rates that are likely to prevail over a period, possible levels of inflation in future, etc.

(g)    Decision Criteria – In order to be in a position to take a decision at the end of the Cost-Benefit study, one has to fix a set of decision criteria. This involves the following considerations –
(i) Time period over which costs and benefits are to be considered. Normally this would be over the entire life of the project. However, deciding the life of the project itself may be difficult.
(ii) Accept-Reject criteria – The general rule would be that if C < B then the project is good and should be accepted. However, this may require modifications. So for a private investor he may want the benefits to exceed costs by a certain percentage as a matter of abundant caution. On the other hand, governments may decide to go ahead with the project even if the benefits are slightly higher than the costs in the interest of social welfare.

Uses of C-B Analysis –

Private C-B Analysis – can be of assistance to an investor to decide whether or not to invest in a particular project.

Social C-B Analysis – is normally conducted by the government while taking up social welfare project. However, it is important to note that quite often it would be advisable for the Private Sector to conduct a Social C-B analysis of their projects. Advantages of such an analysis may be the following –

(a)    It helps the Corporate Sector to keep track of its record as a Social Citizen. Being a good Social Citizen can be a marketing advantage. However, more importantly it can be pursued as an end in itself.

(b)   Social benefits arising out of a project can be leveraged with the governments while negotiating for tax concessions and such other incentives for the project.

(c)    A deeper understanding of the issues in valuations and methodology of compensation may result in innovative ways of resolving compensation issues that do not directly affect the profitability of the project. For example – If land is acquired for a project for a particular amount, the company may not be willing to give additional compensation in terms of money as this will affect the profitability of the project. However, it may be more than happy to consider employing a member of the family whose land has been acquired. Also the farmer who has lost the land may feel that a job is a more meaningful compensation than a few additional rupees. Thus a detailed Social C-B analysis can result in a win-win solution for all concerned.

Comments»

1. Chiputa Musemo - April 19, 2011

Great help in my assignment, very elaborate and to the point.


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