In this video I’ll explain cost-benefit
analysis. By the end of this video you will be able
to explain how to conduct a cost-benefit analysis. You’ll also learn how to analyse the limitations
of a cost-benefit analysis. When considering whether or not to pursue
a public investment project such as building a highway or installing a traffic light, a
government would undertake a cost-benefit analysis to assess the value of the project
and also see whether or not they should progress with it. The issue lies in determining the value of
benefits and costs. How do we appraise the present value of some future benefits? While
we can gather as much information as is available, accurately placing value on costs and benefits
is quite a difficult process. I’ll illustrate with an example. Imagine an intersection without stop signs
or traffic lights. There’s a significant amount of traffic that flows through the intersection
on a daily basis, and from time to time, there are accidents. The city is deciding whether or not to introduce
traffic lights at the intersection. How would they value the benefits of putting up a traffic
light? While they're deciding whether or not to put
up the traffic light, the following incident occurs. The drivers seen just before are continuing
along their daily commute when one car breaks down in the intersection. For some reason,
the van driver is playing on a mobile phone and doesn’t look up in time to see the broken
down car. There’s a fatal car accident and neither
driver survives. The question is, how do you place a monetary value on an individual’s
life or wellbeing? This is one of many problems that governments face when pursuing such projects.
It’s somewhat easy to estimate the costs of the materials and services needed to put
up the traffic light, but its difficult to estimate the benefits accurately. Add to the
problem that people don’t pay to use the traffic light and determining its value becomes
much more difficult. Let’s look at a sample analysis the government
may conduct. This table considers four options and their
associated benefits and costs. There are external benefits and costs for each option. We add together the private and external benefits
and compare them to the private and external costs. We use this information to derive our
net benefit or net cost. Using this information, we select the project with the highest net
benefit to pursue. Let’s consider option 1. The sum of the benefits is $120,000 and the
value of the costs is $180,000. Since our costs are greater than our benefits, we run
a a net loss of $60,000. Let’s use the same approach to solve for the rest of the options
and see if we can find one with a positive net benefit. Moving on to option 2 we can see that the
sum of the benefits is $220,000 and the costs are $205,000. The net benefit is therefore
$15,000. Moving on to option 3 we can see that the
sum of the benefits is $230,000 and the costs are $220,000. The net benefit is therefore
$10,000. Moving on to option 4 we can see that the
sum of the benefits is $240,000 and the costs are $300,000. The net loss is therefore $60,000. If we select the option with the greatest
overall benefit, then option 2 would be the obvious choice. Remember, just because we’ve
identified the option with the greatest benefit, we should be careful about the value of the
data collected. That plays a big role in the value of a project and results of a cost-benefit
analysis. Alright, you’ve made it through the final
video in unit 1and you should now have a good understanding of cost-benefit analysis. You’ve
seen how to conduct one and have heard some of the limitations of being able to collect
valuable data. If you have any questions you can leave them below or email me at enhancetuition@gmail.com
or visit me online at www.enhancetuition.co.uk. That’s us done for now and I will see you
in unit 2!
