Economists, and more recently, courts and policy-makers, use B-C techniques to analyze many natural resource issues. The basic approach determines the policy choice or level of the decision variable which yields the maximum discounted net benefit stream. In theory, we can compare the marginal benefits and marginal costs of a policy variable Q. Total net benefits are maximized where MB = MC, i.e. where marginal net benefits are zero.
More practically, we are often required to choose between a set of discrete policy options. The usual decision process involves calculating a B-C ratio for each option and immediately ruling out options with B-C < 1. At this point, the optimal choice may be the option with this highest B-C ratio (if that option is scalable), or the option with the largest B-C difference (if the options are not scalable).
B-C analysis is rarely straightforward. Benefits and costs may accrue in different time periods, requiring use of discounting, and the choice of discount rate can have a dramatic influence on B-C ratios, even reversing B-C rank orders of alternatives. In addition, analyses generally use projections of future benefits and costs, and need to deal with uncertainty about these.
Environmental Benefit Estimation Methods
Example 1: A proposed dam in Hell's Canyon on the Snake River between Idaho and Oregon would generate hydro power but eliminate existing scenic and recreation resources. In a lawsuit to block construction of the dam, the court accepted plaintiffs' B-C analysis comparing the projected marginal value of hydro power (versus next-cheapest power) against the value recreation benefits which would be precluded (measured via travel-cost analysis--see below). The court also considered the irreversibility of development versus preservation.
Estimating the economic benefits and costs of alternative policies can be quite complex because (1) market failures imply most environmental amenities are unpriced non-market goods whose economic values are difficult to measure; and (2) policy choices frequently involve risk to human health or life.
Economists have developed various benefit estimation methods for evaluating environmental amenities. One class of methods involves analysis of the effects of environmental quality changes in markets for related goods. These "related-market methods" quantify shifts in demands for market goods caused by changes in the level of an environmental amenity: the change in consumer surplus quantifies the cost or benefit of the amenity changes.
Another class of valuation methods involves surveys using hypothetical scenarios designed to elicit respondents' valuations of environmental quality changes. These "non-market methods" may have respondents state their willingness-to-pay for an environmental amenity directly, or indicate preferences between alternative quality/payment scenarios from which WTP for changes in the environmental amenity can be imputed.
Incorporating Risk in to B-C Analyses
Environmental damage assessments require (1) cataloging types of damages; (2) analyzing the physical linkages between pollution and damage; (3) analyzing how affected parties partially offset damages; and (4) calculating total environmental benefits lost.
Physical linkages can be hard to determine: we can't experiment on humans. Toxicologists use high-dosage short-term animals experiments to estimate low-dosage long-term effects on humans. Statisticians analyze correlations between pollutant exposures and human morbidity or mortality rates, but correlations don't necessarily imply causality. Different pollutants may have synergistic effects, being far more harmful in combination than individually. Pollution exposure variables may also be collinear with other variables (age, income, race), so pollution effects are hard to disentangle from other effects.
Not only are actual risks difficult to quantify, but public perceptions such risks are often highly distorted. People also resist placing any dollar value on health or life (although courts do it all the time). However, economic self-valuations are implicit in their behavior (smoking, not wearing seat belts). In theory, people can evaluate health and lives meaningfully under Rawls's "veil of ignorance."
Estimating the costs of environmental improvements is generally less interesting. Economists typically leave this to engineers who are most familiar with pollution abatement technologies.
Since the future is uncertain, we often have to compare alternative policy choices Ci with differing probabilities Pij of alternative outcomes Oj. We evaluate the different outcomes, discount these to present-value terms, weight (multiply) these present values by their respective probabilities, sum these, and choose the choice with the highest expected net present value. This process implies risk-neutrality. If we are risk-averse, we adjust the present values of more favorable outcomes downward relative to the present values of less favorable outcomes.
Since B-C analyses may be highly sensitive to the choice of discount rate, OMB directives (arbitrarily) specify a uniform rate of 10 percent. Big projects often involve a lot of "pork-barrel" politics which gets in the way of objective analysis. A lot of "pork" projects involving huge up-front costs and deferred benefits aren't justified except at very low rates of discount.
Alternatives to B-C Analysis
Cost-effectiveness analysis involves choosing a specific policy objective and then determining the least-cost method of achieving it. This ignores the problem of choosing the correct objective.
Impact analysis skips converting all benefits and costs to a single (money) metric. Environmental impact analyses basically catalog physical impacts, policy alternatives, mitigation options, short-run vs. long-run trade-offs and irreversibilities.