USING CBA FOR DECISION MAKING

As long as analysts view all impacts in

terms of willingness to pay and value all
inputs in terms of opportunity costs, then
the sign of net benefits indicated whether
it would be possible to compensate those
who bear costs sufficiently so that no one
is made worse off and at least one person
is better off.
CBA has the following decision Rules:
(a) Adopt any policies that are actually
Pareto efficient.

....continued
Although conceptually appealing such a rule
would be difficult to apply in practice
because: (a) It would place a great burden
on analysts not just to measure aggregate
costs and benefits but also to measure the
costs and benefits for each person.
(b) Once the costs and benefits are known,
the administrative costs of actually making
the specific transfers would be very high.

continued
(c) Difficult to operate a practical
system of compensation payments
that does not distort the work
behavior of households etc.
(d) The requirement that everyone
be fully compensated would create a
strong incentive for people to find
ways to overstate the costs and
understate the benefits.

.continued
Potential Pareto Efficiency
CBA utilizes an alternative decision
rule based on the Kaldor-Hicks
criterion. A policy should be adopted
if and only if those who will gain
could fully compensate those who
will lose and still be better off. It
provides the basis for the potential
Pareto efficiency rule or the net
benefits criterion.

continued
In practice whether particular
policies increase efficiencies depends
on whether they represent potential
Pareto improvements.

APPLICATION OF THE RULE IN PRACTICE

Two policies can be thought of as

independent if the adoption of one does not
influence the costs and benefits of the other.
When all relevant projects are independent,
the CBA rule is simple. Adopt all policies
that have positive net benefits.
A more general version of the rule applies in
situations involving multiple policies that
may enhance or interfere with each other.
Choose the combination of policies that
maximize net benefits.

..continued

Issues Related to Willingness to Pay

Dependence of Willingness to Pay on the
Distribution of Wealth
The willingness of a person to pay to obtain a
desired policy impact will tend to be higher the
greater the wealth that she or he has available.
CBA depends on their levels of wealth. If the
distribution of wealth in a society were to be
changed, then it would be likely that the sum of
individuals willingness to pay amounts would
change as well.

continued
Pareto improvement guarantees that
the sum of utilities of individuals in
society increases. However it is
possible that an adopted policy
lowers the sum of utilities.
The implications of this are that
potential Pareto principle weakens
for policies that concentrate costs
and benefits on different income
groups.

continued
Critics of CBA sometimes question the
validity of the concept of Pareto
efficiency b/c it depends on the status
quo distribution of wealth.
Some have advocated the formulation
of a social welfare function that maps
the utility, wealth or consumption of all
individuals in society into an index that
ranks alternative distribution of goods.