Basic rules of the game
There are four main principles of cost-benefit analysis:
- Consumer sovereignty
- Valuation of goods according to willingness-to-pay
- Pareto-optimality as the criterion of welfare maximisation
- Neutrality with respect to income distribution
Consumer sovereignty is the principle that the choices made by consumers with respect to how to spend their income are accepted and are treated as data. Economists are not moralists. They will not say that someone who spends most of his income on alcohol, tobacco and unhealthy foods is a fool, whereas someone who saves part of his income for old age, while spending the rest prudently on safe foods and safe activities is a wise person. Economists simply treat individual demand for various goods and services as data.
The value of improving road safety is indicated by the willingness-to-pay for reduced risk of injury. Willingness-to-pay is the measure of benefits used in cost-benefit analysis. Assessing willingness-to-pay for non-market goods like road safety is a complex task, involving many potential sources of error. Hence, a common objection to the willingness-to-pay principle is that it is not possible to obtain credible estimates of willingness-to-pay. A more fundamental objection is that willingness-to-pay depends on ability to pay. The rich can afford to pay more for road safety than the poor. If the distribution of income is highly unequal, an indiscriminate use of the willingness-to-pay principle may lead to the provision of non-market goods, like road safety or cleaner air, only to the richest groups of the population. Since road accidents represent a threat to human health, one could argue that all groups of road users ought to have equal access to measures intended to improve road safety, irrespective of their individual demand for it.
In response to these points of view, three arguments can be made in favour of basing the provision of road safety on the demand for it, as manifested in the amounts that individuals are willing to pay for safer roads. In the first place, it is never the case that the provision of road safety – at least when it is a public good – can be matched exactly to individual demand for it. The rich may state that they want to pay a lot for road safety, the poor may state that they cannot afford to pay anything, but both groups benefit when roads or cars are made safer. It is just not possible to match supply and demand at the individual level, as opposed to the case for most market goods (in the sense that, as a rule, we buy the mix of commodities that gives us the greatest satisfaction). In the second place, it is in principle possible to convert the amounts of money individuals are willing to pay for road safety to utility terms, by estimating the marginal utility of money. By converting monetary amounts to units of utility, one may account for the fact that giving up 1,000 Euro is a much smaller sacrifice for a rich man than giving up, say, 250 Euro would be for a poor man. At present, however, converting money to utility is not an easy task. In general, economists will recommend using the willingness-to-pay principle provided it does not lead to unacceptable changes in income distribution. What counts as “unacceptable” in this respect is, of course, ultimately a matter of politics. In the third place, basing the provision of road safety on the demand (willingness to pay) for it ensures that it is not overprovided. Road safety is overprovided if overall welfare can be improved by transferring resources from the provision of road safety to the provision of other commodities.
Pareto-optimality is the third principle of cost-benefit analysis. A measure is Pareto-optimal if it improves the welfare of at least one person without reducing the welfare of any other person. In practice, few measures taken by government will be strictly Pareto-optimal. There will almost never be only gainers and no losers. Hence, the criterion commonly applied in cost-benefit analysis is a weaker criterion, the criterion of a potential Pareto-improvement. This criterion is satisfied when those who gain from a measure can compensate those who lose from it (in utility terms), while still retaining a net benefit. A measure is commonly regarded as satisfying this criterion if its benefits are greater than the costs.
The fourth principle of cost-benefit analysis is that it remains neutral with respect to the distribution of benefits and costs among groups of the population (or groups of road users, for that matter) – provided of course that benefits in total exceed costs. Cost-benefit analysis not intended to help find the most equitable solution to a social problem, only the most efficient solution. To the extent that realising a desired distribution requires the use of other policy instruments than those sanctioned by cost-benefit analysis, it follows that actual policy priorities cannot be based on cost-benefit analyses exclusively.