Chapter Six

Social Cost Benefit

Analysis
It became important in late 1960s and early
1970s (Public Projects)
Social Cost Benefit Analysis (SCBA) is a tool
developed for evaluating projects from the
society’s point of view
It is used mainly to evaluate public projects.
Now a days it is also getting importance in
private investment project as they have to be
approved by different government agencies.
SCBA is different from financial analysis in that,
 Financial analysis takes into account only those
costs and benefits falling on the decision
maker
 It also focus only on those tangible benefit or
costs
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In General, SCBA is a social decision
making machinery, which evaluate all
major intangible costs and benefits arising
form a contemplated course of action
 Need for SCBA?
Financial Cost-benefit analysis is quite
successful in quantifying the tangible
benefits and costs so as to choose the best
project with the highest BCR or NPV
However, such analysis failed to evaluate or
assign value for intangibles like, benefit
to the natural environment and to the
society
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The essence of the SCBA is that the actual

receipts of a project do not include or
reflect the social benefits of the project
The actual expenditures does not include
social costs either
The reason is that market prices may be
inadequate indicator of economic benefits and
costs.
Which means some projects which seems very
profitable when they are valued at market
prices might be unattractive from the viewpoint
of the society,
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As a result, SCBA deviate from the financial

(private) cost and benefit of the project.
The major sources of differences are due to
market failure
The market price which forms the basis for
computing the monetary cost and benefit from
the point of view of the project owner will not
reflect social values
This is due to the existence of
Public Goods ( Collectively consumed
goods)
Externalities
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Public Good (Collectively consumed goods)

These are goods served (consumed) on the basis
first come first serve.
Public goods are goods that are
Non-excludable: It is not possible to exclude
others from consuming public goods
Non rival in consumption: Once they are
available the additional consumption up to
capacity constraint does not reduce the
availability of the good
The free rider problem arises when a consumer or
producer doesn't pay for the use of them
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 Social Cost Benefit Analysis(Cont
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Externality
Due to the existence of public goods (collectively
consumed good) for which every one has free
ride, the problem of externality exists
Market fails to assign value to externalities as
they occur outside the market transaction.
Externality is said to be exist when the
production / consumption activity of one
party affects the production/consumption
activity of another party without any
payment for the effect
Externality can be either positive or negative
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Negative externalities
Project may have a harmful external effect
like pollution
 pollution produced by local automobiles,
 Sound produced by economic agents
 Water pollution by a steel industry
Positive externalities:
Project may create certain infrastructure
facilities like road which will benefit people in
the nearby community
 pleasure from observing your neighbor's
flower garden
 an orchard located next to a beekeeper.
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If there are externalities, there is deviation

between private and social benefits and costs.
The equilibrium condition for the private
decision-maker is Marginal Private Cost (MPC)
equals to Marginal Private Benefit (MPB), i.e.,
MPC=MPB
For the society, an efficient allocation requires
that Marginal Social Cost (MSC) equals to
Marginal Social benefit (MSB), i.e., MSC =MSB .
If there is positive externality in production the
firm produces at point where MPB = MPC. But
this is different from the socially efficient level
as MSB (= MPB+MEB) > MPB. (E=External ) 8
 Social Cost Benefit Analysis(Cont
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Such positive or harmful effects of the project
are not valued by the market as they are
intangible and the transaction takes place
outside the market.
Redistribution effect: A private project
mostly are not concerned how the benefits
are distributed across various groups in the
society.
The society is , however, concerned with the
distribution of benefits across different
groups.
In the SCBA redistribution effect of the
proposed project is also considers in
evaluating the project. 9
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In choosing a particular project the additional
benefits derived from a particular project should
exceed the corresponding additional cost
The cost benefit analysis can be undertaken in
three steps
Step-1: This step involves the identification of
alternatives to be assessed.

Step-2: In this step a prediction of the likely

consequences associated with each alternative
projects
This means the likely effect of the project on the
social and environmental aspects is predicted
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 Social Cost Benefit Analysis(Cont
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For Example:
Consider a development project - Construction of
Dam.
In this step the possible intangible benefits that a
project may bring to the community and on the
environment is predicted.
These are benefits like,
The number of unemployed people that would
get employment opportunity
Benefit obtained from the infrastructure
improvement (saved time , reduced cost, etc.)
Decrease yearly flood damage (soil erosion,
deforestation, reduced property damage )
Recreational benefit to the society
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Intangible Cost (harmful impact of the project)

 Deforestation created by the project
 Number of people displaced from the
site
Example 2
Consider the Railway project:
Here we need also to identify and describe
changes that can be brought out by the
project in the transport sector.
The Railway projects might have the following
social benefits and costs
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 Social Cost Benefit Analysis(Cont
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Potential benefits:
It reduces motor vehicles operation and
maintenance cost to both government and
private sector as they switch over from
road to railways.
It will reduce travel time of people using
the road (opportunity cost of time)
Reduce atmospheric pollution in the city
Reduce investment and operation cost of
road
Reduce traffic accident in the city
Expected cost of the project
Loss of revenue to private investor
Number of people losing their job 13
 Social Cost Benefit Analysis(Cont
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Step-3: Involves the task of estimating

(assigning) values for the cost and
benefits occurring as a result of
implementing the project
Estimating the cost or the benefit of intangibles
is some what difficult and require the
application of both direct and indirect method.
Consider the case of a project that might cause
damage on the environment say, west
disposal to the river or air pollution
Let us consider the nature of the cost involved
in environmental quality (cost valuation)

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 Social Cost Benefit Analysis(Cont
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Cost of environmental problem refers to the

west disposal cost imposed on the society by
the production and consumption activities of the
project
West Disposal Cost: is the sum of pollution
prevention cost and pollution cost (i.e.,)
West Disposal Cost = Pollution Prevention
Cost + Cost of Pollution
Pollution Prevention Cost: are those costs
incurred to prevent the pollution either partly or
fully.
These are costs like,
Costs incurred by local government (society) to
treat its sewage before dumping it into the river.
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 Social Cost Benefit Analysis(Cont
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One example of social cost of pollution

prevention is
the additional transport cost accepted by
suburban dwellers who work in a city.
Some people prefer to reside in suburbs
and incur additional expense on transport
rather than be a part of the polluted
atmosphere in the city.
These costs are incurred for the purpose
of avoiding the problem of congested city
and hence come under pollution
prevention cost. 16
 Social Cost Benefit Analysis(Cont
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Pollution Cost: these can be either pollution

avoidance cost or welfare damage cost.
Pollution avoidance costs: are private or
public expenditure made to avoided pollution
damage once pollution has already occurred
Once the environmental damage has occurred
a society can choose either to avoid the
damage through some remedial measure or to
bear it
The cost of such measure is considered as a
best estimate to value the damage (cost of
the project) 17
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Welfare Damage: The damage that are

neither prevented nor avoided cause welfare
damage.
Such damages are both real and financial.
These are observable deterioration of physical
asset and properties.
It can also be in the form of deterioration of the
health of living beings.
Projects that results in water and air
pollution create health hazards and
increase the medical expense to the society
to maintain a given standard of health
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 Social Cost Benefit Analysis(Cont
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There are, certain welfare costs of pollution

damage which can not be directly measured.
At most we can measure them by finding
out sum of money needed to pay to avoid
such damage.
In general,
West Disposal Cost = Pollution Prevention
Cost + Pollution
Cost
Pollution Cost = Pollution Avoidance Cost
+ Welfare Damage Cost
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 Social Cost Benefit Analysis(Cont
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Waste disposal costs are in general

alternative costs of real cost
That is, direct and indirect outlays that could
be incurred either to prevent pollution
before it occurred or to avoid the damage
from pollution after it has occurred.
The pollution damage cost to the society
increases with pollution increase.
This is shown in the diagram below

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 Social Cost Benefit Analysis(Cont
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Direct methods Indirect Method

Conventional Hedonic Cost based

1. Contingent Market approach Approach methods
valuation
method
2. Trade of
games method 1.Household Production
1. Productivity
3. Costless function approach 1.Replacement
approach a Travel Cost approach Cost approach
choice method 2.Human capital or b. Preventive 2. Relocation
4. Delphi foreign earning expenditure approach
cost approach
Technique approach 2. Surrogate Market
approach 3. Opportunity
3. Dose response
a. Property Value cost approach
approach
approach
b. Wage Differential
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approach
 Social Cost Benefit Analysis(Cont
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1. Direct method
Direct methods are largely based on survey
These methods are useful in valuating the
benefit of a project where indirect methods
are inadequate.
Direct method is an attempt to elicit
preference directly by the use of survey and
experimental technique
Here belong methods like,
 Contingent valuation method (CVM)
 Trade off game methods
 Costless choice methods
 Delphi method 22
 Social Cost Benefit Analysis(Cont
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Trade off game method: Trade of games

are used to determine individual
preferences among verities of outcomes.
To understand this simply let us assume
that there are two parts of each outcome.
A certain sum of money and a certain
quality of environmental or social
goods
The base outcomes are a combination
of certain level of environmental
quality plus no money (no payment). 23
Social Cost Benefit Analysis(Cont
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OUTCOME ONE: Base outcome

Environmental quality
No Money

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 Outcome two
Improved quality of environment plus
certain amount of money (cost to the
society)

Outcome two: Willingness to pay

for certain level of environmental
quality

Improved quality of
Environment or social goods Certain amount of
money

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 Social Cost Benefit Analysis(Cont
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The individual is asked to reveal his preference
between the two outcomes.
The amount of money in the outcome two is the
amount that the individual is willing to trade off
for the improvement of the environmental
quality specified in the option.
The value of this trade of money is increased
gradually until the individual decide to be
indifferent between the two outcomes.
The amount which makes him indifferent
between the two outcome is his willingness to
pay for the specified increase in the
environmental quality of goods.
By interviewing an adequate size of population
the willingness to pay is estimated. 26
 Social Cost Benefit Analysis(Cont
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2. Indirect Method
These are the method largely used on the
basis of actual peoples behavior in contrast
to the use of hypothetical situation.
The indirect method could be of the following
type
a) Conventional Market Based Approach
 Productivity approach
 Human capital/foreign earning approach
 Dose response approach

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b) Hedonic Pricing Approach: Which can be

either
 Household production function
approach
 Travel cost
 Preventive expenditure
 Surrogate market approach
 Property value approach
 Wage differentiation

c) Cost based method

 Replacement cost
 Relocation cost
 Opportunity cost 28
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A. Conventional Market Based

Approach: This method of valuating
benefit relies on the actual market price
of the product, the production of which
has consequence on environment.
This approach may take the form of
Productivity approach
Human capital or Foregone earning
approach
Dose response approach
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 Social Cost Benefit Analysis(Cont
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The productivity approach: In this method

environmental factors are viewed as a factor of
production.
Change in environmental quality lead to changes
in productivity which in turn will affect the price
of the product through a change in output.
Such changes can be observed and measured.
For example,
A reduction in soil erosion may increase yields.
Comparison of output with and without soil
conservation scheme shows the difference in
productivity arising from soil conservation.
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 Social Cost Benefit Analysis(Cont
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Like wise, improvement in the water

supply by reducing salinity may improve
the crop productivity.
Similarly a project which brings adverse
effect on the quality of soil (erosion or
pollution) may result in reduction in crop
production.
In such project which results in water
quality improvement (soil quality), change
in the output multiplied by the price of
output give us an estimate of the benefit /
cost of the project.
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Thus, in the productivity approach a

change in environmental factors is said
to influence the production function
and hence the supply of marketable
goods from the given resources.
The value of change estimated through the
market price of the goods is hence used as
a measure of the benefit or loss resulting
from a change in environmental quality.

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