On Balance: Review of "Cost Benefit Analysis" by Per Olov Johansson and Bengt Kristrom

   October 24, 2018

   By Emile Quinet

   Cambridge Elements has created a series on Public Economics, edited by Robin Boadway, Frank Cowell and Massimo Florio. This is part of a major project by Cambridge University Press, which is intended to provide peer-reviewed analytical surveys and frontier topics in all the disciplines. We happily note that the first published “Element” in this series is Cost Benefit Analysis, by Per-Olov Johansson and Bengt Kriström (2018). Cost-Benefit Analysis is available as a free download for a limited time, and is for sale (relatively inexpensively) in print at Cambridge and at online booksellers, such as Barnes and Noble. The Element is just above eighty pages (plus a short technical annex and a long list of references).

Encompassing the whole of Cost-Benefit Analysis in such a reduced volume is a tour de force, as acknowledged by the authors in the prologue. The aim is to provide a comprehensive and non-technical state of the art overview of Cost-Benefit Analysis, including both basic classical results and some new frontiers. It has been successfully reached.

The authors’ task is made easier by a book they co-authored in 2015, Cost Benefit Analysis for Project Appraisal, which was about three times as long as the Element. While of course the authors build on this source, the Element has several differentiating features.

First, the 2015 book was limited to project appraisal, a focus well in line with European concerns, where cost-benefit analysis has long been applied to infrastructure investments, especially investments in transport and environmental services. The Element has a broader scope and may capture a wider audience, particularly in the United States, where cost-benefit analysis has been used not only to assess investments, but also in evaluating regulations, as a result of the Executive Order (EO) 12866, which imposes “…an assessment of all costs and benefits of available regulatory alternatives, including the alternative of not regulating.” (See also a recent On Balance post by Clark Nardinelli and Susan Dudley.)

Second, in contrast to the earlier book, the use of mathematical equations is relatively limited in this Element, which is nontechnical and instead mainly uses simple graphs and literal explanation. The authors address many tricky issues, such as market power or cost of public funds, in simple and transparent ways. For each of these complicated issues, examples are provided to make the spirit of the concept or of the mechanism understood, and are supported by numerous references. Many of these references come from Nordic countries, especially Sweden, and serve also to highlight the achievements of Swedish economists.

Following a Prologue (Section 1) and Introduction (Section 2), the Element is divided into five sections. Section 3, entitled Basic Rules, deals with classical issues, starting from the Dupuit surplus (now known as consumers’ surplus) in a single market, and extending the discussion to multiple markets, including the case of foreign exchanges. The authors then broaden the discussion to include public goods and externalities, non-use values, paternalism and altruism, and, finally, tradable permits, market powers, and market imbalances.

Section 4 deals with discounting and distributional issues; distributional issues are rightly emphasized, as they are often omitted by practitioners. The authors do a good job linking theory to practice, and explaining how the first can be of use for the second; the same can be said for their discussion of the cost of capital.

In Section 5, the authors develop the distinction between large and small projects. This development is largely built on the chapter on same subject in their 2015 book. It is in my view one of the most interesting contributions of the book, pointing to a rarely addressed issue: linking sound theoretical considerations to the implications for practical implementation. This section also includes a discussion of the caveats associated with transferring values from one study to another, which should be read by all practitioners. It also addresses risk issues, and provides an interesting and short presentation on the value of flexibility.

Section 6 deals with valuation of non-market goods. Here the authors cover rather technical developments that will be difficult for non-specialists to understand. However, they do provide broad views and interesting comparisons of different empirical approaches to valuing non-market goods (including the household production function approach).

In Section 7, the authors deepen some previous points. For instance, they come back to the distinction between small and large projects; they compare numerical simulations of three different methods for large project appraisal, leading to impressive discrepancies and showing how easy it is to make mistakes in this field. They also report some developments on the value of statistical life. While these topics are quite interesting, it is unclear why they, in particular, are presented rather than other equally interesting ones.

The authors’ ability to address classic topics in a simple illustrative manner that nevertheless leads to very penetrating conclusions is the mark of their deep understanding of the matter. I especially appreciated the useful guidance they provide for the practitioner: for instance, how to take into account ad valorem taxes—depending on demand elasticities—or how to take into account imbalances in the labor market—an especially difficult and important issue.

Just a regret: the book does not deal with the issue of decision criteria in investment appraisal; it gives some hints on the optimal timing of investment (in the section on distributional issues), but does not address the full problem of optimal programming. Nor do the authors give any indication of how to use the usual indicators (such as net present value, internal rate of return), even though this is a subject of major interest for practitioners, and is rarely addressed by books on cost-benefit analysis.

On the whole, the authors demonstrate an enviable ability to explain concepts and mechanisms with very simple sentences and examples. They do not hesitate to return to the definition of rather basic concepts, such as externalities, or public goods, using enlightening illustrations. They introduce more refined concepts with short sentences. I was especially struck by their elegant and concise way of introducing risk: “In order to be able to say anything meaningful about attitudes toward risk we must assume that the utility function is concave or convex. Concavity or convexity of a function is a cardinal property. Therefore we now leave the ordinal world….”

While laudable, the use of words without mathematical or technical apparatus has its limits and raises the question, “will this book be understood by the reader who has no background in economics?” It is probable that non-specialists will pick up the general meaning of the definitions, but sure that they will not fully understand all the subtleties in this book, which is short in length but long to read, and which is like a diamond: splendid and hard.

Rather, the audience for this book is likely to be the graduate student of economics who plans to specialize in cost-benefit analysis. Practitioners, especially consultants and those in government, will find deep insights on difficult matters rarely addressed in official guidelines. These readers will find in this book a systematic overview of all important themes of cost-benefit analysis and many references facilitating a deeper understanding of the topics. And specialists of all types will find much food for thought.

Emile Quinet is associate member of Paris School of Economics and emeritus professor at Ecole des ponts-ParisTech. He is specialized in transportation and Cost Benefit Analysis. He is the author of several reports to the French Government on Cost Benefit Analysis guidances.

References

  • Johansson, P., & Kriström, B. (2018). Cost–Benefit Analysis (Elements in Public Economics). Cambridge: Cambridge University Press. doi:10.1017/9781108660624
  • Johansson, P., & Kriström, B. (2015). Cost-Benefit Analysis for Project Appraisal. Cambridge: Cambridge University Press. doi:10.1017/CBO9781316392751