Higher Rock Education - Economics Blog

Tuesday, May 16, 2017

What is a Cost-Benefit Analysis?

Economists recommend using cost-benefit analysis when identifying the "best" solution, whether it is for personal decisions or for government policies. The costs of the program are subtracted from the benefits. If the result is negative, then not proceeding is the correct decision. If there are more than one option, and several are positive, then the one with the greatest benefit should be pursued. Simple, rational solution which works every time; that is in theory. The challenge is quantifying the costs and benefits.

Most of us have listed the pros and cons at some point when faced with a decision. Go ahead, make your list. Now try to quantify in monetary terms each of the items listed. You have just performed a cost-benefit analysis. For example, assume you are trying to determine what college to attend, and you list out the following costs and benefits of two schools.

School 1 School 2

Beautiful Campus
Academic Reputation
Athletic Program
Friends attending
Ease to get a job after graduation
Extracurricular Activities
Total Benefits
Total Costs

Go ahead and complete the table. Tough isn't it. There are many items such as the beauty of the campus, ease to get a job after graduation, and extracurricular activities that are hard to quantify. Others like tuition, travel, housing, and scholarship are easy to value.

The challenge to a cost-benefit analysis is quantifying the costs and benefits

In 2017 Kentucky Paul Rand and Attorney General Jeff Sessoms disagreed on the monetary value of different policies. Their disagreement illustrates the difficulty in quantifying costs and benefits. AG Sessions instructed prosecutors to "pursue the most serious readily provable offense" and that these "carry the most substantial guidelines sentences, including mandatory minimum sentences." (May 10, 2017 Memo to Federal Prosecutors) This means that convicted non-violent drug abusers may be sentenced to very long prison terms. This reverses a policy by Attorney General Holder under the Obama administration that concluded that lengthy prison terms for low-risk inmates was too costly both in terms of money spent on incarceration and the cost to the inmate and family. In other words, the penalty does not fit the crime. Senator Paul Rand of Kentucky disagrees with Attorney General Session's policy. (CNN) I assume each has done their own cost-benefit analysis and have reached different conclusions of what is in the best interest of the United States. Most studies conclude that the cost of incarceration is higher than the cost of rehab. The Bureau of Prisons reported in 2015 that the average cost to incarcerate an inmate is $30,620 per year. A study by the National Institute of Health concluded the cost of methadone treatment was $4,700 per year. Other estimates are as high as $60,000. However, even this high estimate is less expensive than two years of incarceration. Senator Rand would also include the cost to the inmate's family. Attorney General Sessions would argue that Senator Rand's costs are too low because they do not include the probability of a crime being committed after a prisoner is released. In addition, it neglects the deterrence a long prison sentence would have on potential criminals.

In this case, like many cases when policy is involved, cost-benefit analysis can lead to two different conclusions because so many of the costs and benefits are subjective. Does that make cost benefit analysis useless? Absolutely not. Cost-benefit analysis helps students, policy makers, voters, and everyone else reach the best decision for them by providing a disciplined approach to reach any decision. Next time you make an important personal decision, or write an analytical paper, or debate a friend, I suggest doing a cost-benefit analysis. I think you will find it helpful.

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