This document discusses using cost-benefit analysis in policy making. It outlines the overall policy making process and how cost-benefit analysis can inform it. Cost-benefit analysis aims to optimize economic welfare by quantifying the costs and benefits of policy options. However, policy makers consider multiple objectives and criteria in decisions. While cost-benefit analysis provides a framework, there are challenges in applying it due to uncertainties and difficulties quantifying all impacts. Judgement is still needed in policy making.

1. Using cost-benefit analysis in
policy making
18 November 2013
Tera Allas
Director General, Strategic Advice
Department for Business, Innovation and Skills

2. 2
Using cost-benefit analysis in policy
making: outline of today’s discussion
• Overall policy making process and role of cost-benefit
analysis in it
• The objective function(s) and decision making criteria in
government policy making
• Using cost-benefit analysis as a framework and
quantitative tool to inform policy making and decisions
• Key concepts in cost-benefit analysis without which
conclusions are suspect
• Challenges in applying cost-benefit analysis and the role
of judgement

3. 3
While not linear in reality, the broad policy
making process is made up of key stages
Simplified overview of the policy making process
Consultation
Understand
the
problem
Scope the
policy work
Collect and
analyse
evidence
Recommend
policy to
Ministers
Clearance:
Cabinet
Committee,
RPC
Delivery –
including
legislation if
applicable
Identify, develop
and test policy
options
• What is the
problem?
• What are the
outcomes?
• Who are the
stakeholders?
• What are
government’s
levers?
• Major overhaul
or minor
adjustments?
• Early
engagement of
Ministers and
Spads
• From
Economists
and Analysts
• From
Stakeholders
• Explore innovative
solutions - does Govt have
to deliver, alternatives to
legislation/regulation
• Weigh up – vfm, regulatory
impact, links with existing
policy, etc.
• Test strong options with
stakeholders
• Identify possible
‘unintended consequences’
• Ensure Ministers
make informed
decisions - “no
surprises”
• Delivery plan project and risk
management
• Actions in
Departmental
Business Plans
• Communicating
the policy – Comms
strategy
• Monitoring and
Evaluation – testing
success of policy in
practice

4. 4
Making a difference to outcomes
Analytical approaches have a key contribution to
make in each stage
Identifying
issues
Examples of ways in which economics and analysis add value
Prioritising
issues
• Horizon scanning and analysis of emerging trends
Developing
options
• Using tool-kit of potential interventions to identify options
Appraising
options
Deciding
on policy
Implementing
options
Evaluating
performance
• Identifying market failures that may require rectifying
• Quantifying impact of issues or problems on the economy
• Connecting with citizens’ and businesses’ behaviour/incentives
• Identifying 2nd order consequences through systems thinking
• Modelling impacts and monetary costs/benefits of options
• Helping understand risk and uncertainty in decision making
• Defining meaningful performance indicators and monitoring them
• Communicating messages compellingly with supporting facts
• Monitoring and evaluating outcomes and reporting on them

5. 5
Slightly different frameworks are used to assess
different policy instruments
Main appraisal terminology and tools in use in UK government
Policy instrument
Appraisal tool
Tax
Policy costings* (annex of
budget document)
Spend
Business cases** (5 case
model)
Regulation
Impact assessments***
Information
Depends on whether delivered
through spend or regulation
See for example https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/221895/budget2013_policy_costings.pdf
** See for example https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/190601/
Green_Book_guidance_public_sector_business_cases_using_the_Five_Case_Model_guidance.pdf
*** See for example https://www.gov.uk/producing-impact-assessments-guidance-for-government-departments

6. 6
Using cost-benefit analysis in policy
making: outline of today’s discussion
• Overall policy making process and role of cost-benefit
analysis in it
• The objective function(s) and decision making criteria in
government policy making
• Using cost-benefit analysis as a framework and
quantitative tool to inform policy making and decisions
• Key concepts in cost-benefit analysis without which
conclusions are suspect
• Challenges in applying cost-benefit analysis and the role
of judgement

7. The basic idea behind cost-benefit
analysis is to find a policy “optimum”
Gross costs and benefits
Illustrative shape of costs and benefits of any area of spend
Imaginary monetary units
Optimum is
around here
Net benefits can
be negative!
Scale or scope or sophistication of activity
7

8. 8
Policy makers are often faced with multiple
objective functions to optimise against
Objective functions in policy making
Economic efficiency =
“maximise economic/social welfare”
Public acceptance =
“maximise match with
citizens’ preferences”
Fairness =
“maximise equity and minimise
distributional distortions”

9. 9
Practical, political, legal and technical reasons lead
to multiple decision criteria
Key categories of decision making criteria in policy making
•
•
•
•
•
•
•
•
Economic – e.g., costs and benefits, growth, jobs
Financial – e.g., affordability
Managerial – e.g., deliverability, risk profile
Commercial – e.g., contractual liabilities
Social – e.g., distributional impacts, regional impacts
Environmental – e.g., sustainability, air quality
Legal – e.g., Human Rights, Data Protection, EU law
Other – e.g., information management requirements,
health and safety, consumer focus, design quality

10. 10
Cost-benefit analysis is focused on optimising
economic welfare
EXAMPLE: Economic welfare benefits of science and innovation
“Pure” economic
benefits
Scientific
discoveries
E.g., penicillin, un-aerobic
digestion
Innovations
E.g., text messaging,
high-efficiency gas boilers
E.g., lower resource costs,
consumer/user convenience
Societal
benefits
E.g., improved care of
the elderly, community cohesion
Environmental
benefits
E.g., lower depletion of natural
capital, lower emissions
Total
economic
welfare

11. 11
Economic welfare is not exactly the same as GDP or
growth – but is related
Very roughly (!) Economic welfare = GDP + consumer surplus +/- externalities
Price level
Aggregate
demand
Prices of labour,
goods and services
Aggregate
supply
Consumer
surplus
GDP [at prevailing prices,
taxes and subsidies]
Output
Quantity of goods and
services bought and sold
* Nominal growth – where nominal GDP grows because prices of labour, goods and services increase (inflation) – does not increase employment, living
standards or the Government’s fiscal position (and therefore ability to offer public services); real growth (which strips out inflation) is the appropriate policy goal

12. International comparisons of GDP per capita and life satisfaction
Mean life satisfaction
Source: The Hidden Wealth of Nations, David Halpern (Gallup data; graph from Angus Deaton, Harvard)
GDP is often used as an additional metric due to
comparability and relevance
The size of the circles corresponds to population size
GDP per capita in 2003, 2000 PPP

13. 13
Using cost-benefit analysis in policy
making: outline of today’s discussion
• Overall policy making process and role of cost-benefit
analysis in it
• The objective function(s) and decision making criteria in
government policy making
• Using cost-benefit analysis as a framework and
quantitative tool to inform policy making and decisions
• Key concepts in and elements of cost-benefit analysis
without which conclusions are suspect
• Challenges in applying cost-benefit analysis and the role
of judgement

14. 14
As mentioned, economic welfare is one of
several considerations in decision making
EXAMPLE: Department for Transport decision framework [1/3]

15. 15
As mentioned, economic welfare is one of
several considerations in decision making
EXAMPLE: Department for Transport decision framework [2/3]

16. 16
As mentioned, economic welfare is one of
several considerations in decision making
EXAMPLE: Department for Transport decision framework [3/3]

17. 17
Cost-benefit analysis takes into account
quantitative and qualitative factors
EXAMPLE: Department for Transport value-for-money framework

18. 18
Often it is impossible to conclude much
without some element of quantification
EXAMPLE: Possible costs and benefits of new nuclear power
relative to a counterfactual of new gas fired power stations
Type
Costs
Benefits
Economic
•
•
•
•
•
•
•
Development costs
Transmission costs
Construction costs
Cost of capital
Waste disposal costs
Decommissioning costs
Potential health and safety costs
and/or risks
•
•
•
•
•
•
•
Fear of accidents
Fear of terrorism
•
Social
•
Lower fuel costs
Lower operating costs
Longer economic life
Potential benefits from diversity
Potential innovation spill-overs and
export potential
Potentially lower electricity prices
improving competitiveness of industry
•
Environmental
•
•
Potential contamination
Potential landscape issues
Regeneration in potentially deprived
communities
Potential re-skilling of workforce
•
•
Lower CO2 and other emissions
Fuel source sustainability

19. 19
For example, time savings are often the
biggest element of transport benefits
EXAMPLE: Quantified benefits of roads investment
£1,800
£1,600
Time and
Money
Savings:
Transport
Providers
£1,400
Millions
Millions (NPV)
£1,200
£1,000
£800
Time and
Money
Savings:
Consumers
£600
£400
£200
£0
Carbon Savings Accident Savings
A421 Improvements: M1 Junction 13 to Bedford.
Source: Department for Transport
Total
Benefits

20. 20
Using cost-benefit analysis in policy
making: outline of today’s discussion
• Overall policy making process and role of cost-benefit
analysis in it
• The objective function(s) and decision making criteria in
government policy making
• Using cost-benefit analysis as a framework and
quantitative tool to inform policy making and decisions
• Key concepts in and elements of cost-benefit analysis
without which conclusions are suspect
• Challenges in applying cost-benefit analysis and the role
of judgement

21. 21
There are a few fundamental concepts that underpin
robust cost-benefit analysis
Key concepts underpinning cost-benefit analysis
•
•
•
•
•
•
•
•
•
Rationale for intervention
Time value of money
Counterfactual
Additionality
Monetisation (valuation)
Dynamic effects
Optimism bias
Risk
Option value

22. 22
Government intervention is justified when markets
fail to deliver an optimal outcome
Rationale for government intervention
Type
Explanation
Key reasons
Economic
efficiency
Market failures
mean that the
market-driven
outcome diverges
from a socially
optimal outcome
Public goods
•Non-rival (e.g., clean air) or non-excludable (e.g., defence)
•Problems of free-riding
Externalities
•Costs or benefits are not priced by market and do not accrue to
the agent responsible for generating them
•Positive (e.g., R&D) and negative (e.g., pollution) effects
Imperfect information
•Problems of inefficiency, asymmetry and moral hazard
Market power
•Problems of super-normal rents and under-investment
Equity
Market-driven
outcomes are
considered
inequitable
Differential impacts on different groups
•E.g., city dwellers vs. rural population
•Problems of “winners” and “losers”
Marginal propensity to consume
•Marginal value (utility) of consumption is higher for lower-income
individuals

23. 23
Appraisal attempts to estimate a monetary value
for many non-market goods
“Goods” for which monetary values can be used in appraisal
•
•
•
•
•
•
•
•
•
•
Air quality
Noise
Crime
Ambiance
CO2 emissions
Time savings
Health (QUALY)
Life
Regeneration
Reliability

24. 24
It is important to consider 2nd order price and other
dynamic effects
EXAMPLE: Dynamic effects of improved energy efficiency
Price level
Price of a unit of
“comfort” (e.g.,
warmth, light,
time, convenience)
Demand
Original supply
New supply
Quantity of “comfort”
Quantity of “comfort” supplied
and demanded at any price level
Improvements in
energy efficiency
may in fact result
in higher CO2
emissions

25. 25
Optimism bias needs to be factored into cost and
benefit calculations
EXAMPLE: Cost estimates for High Speed 2
Date
Source
Estimate
March 2010
DfT
£17bn
June 2013
DfT
£42bn
July 2013
Boris Johnson
£70bn
August 2013
Institute of
Economic Affairs
£80bn
Source: http://en.wikipedia.org/wiki/High_Speed_2

26. 26
Using cost-benefit analysis in policy
making: outline of today’s discussion
• Overall policy making process and role of cost-benefit
analysis in it
• The objective function(s) and decision making criteria in
government policy making
• Using cost-benefit analysis as a framework and
quantitative tool to inform policy making and decisions
• Key concepts in and elements of cost-benefit analysis
without which conclusions are suspect
• Challenges in applying cost-benefit analysis and the role
of judgement

27. It is impossible to say in the abstract what
type of transport projects are best
Benefit-to-cost ratios of different typesvs. BCR
All approved schemes, capital cost of transport projects
10
BCR
Benefit-cost-ratio (BCR)
Source: DfT VfM database 2010
Road
EXAMPLE
Bus and local PT
9
Rail
B
Walking and cycling
8
7
6
A
5
4
3
2
1
0
£0-20m
1
£20-50m
2
£50-100m
3
£100-250m
4
Capital cost band
Capital cost band
£250-500m
5
£500m-1bn
6
>£1bn
7 27

28. 28
Traditional cost-benefit analysis can leave
out important macroeconomic effects
EXAMPLE: Estimates of Crossrail benefits and costs
Crossrail's Estimated Benefits
40
Costs
35
Move to more productive
jobs
30
£bn
25
Labour force participation
20
Imperfect Competition
15
10
Agglomeration
5
Business Time Savings
0
GDP
Source: Crossrail and Department for Transport
Cost

29. 29
The results are often highly sensitive to
uncertain underlying assumptions
EXAMPLE: Estimates of net benefits of new nuclear build
over 40 years, £/GW
Source: http://webarchive.nationalarchives.gov.uk/+/http://www.berr.gov.uk/files/file39525.pdf

30. Source: DECC analysis 2008; http://www.economywatch.com/
* Most of the difference for coal and gas fired power comes from changes in fossil fuel prices,
which in turn are highly correlated with oil prices
The optimal electricity mix depends
critically on oil prices which are volatile
Cost of electricity under
different scenarios*
(note: illustrative only)
£/MWh
On-shore
wind
Nuclear
Coal fired
Gas fired
64
82
80
38
Historical oil prices
$/bbl in 2012 dollars
83
40
87
37
Low
EXAMPLE
High
30

31. Economically optimal levels of provision
often feel too low to people and politicians
Estimates of acceptable capacity margin (“spare” supply over
peak demand) in the UK electricity system
EXAMPLE
% of peak demand
25
20
15-20%
15
8-12%
Source: DECC analysis 2007
10
5
0
Generally accepted
Based on cost-benefit
analysis

32. 32
Source: Adapted from MINDSPACE: Influencing behaviour through public policy,
Cabinet Office and Institute for Government
People’s preferences tend to differ from
“economically perfect rationality”
Known preference patterns (“cognitive shortcuts”) that
diverge from “perfect rationality”
Loss aversion
Placing much more importance on
avoiding losses than securing gains
Availability bias
Being overly concerned about unlikely, but
memorable or vivid, events
Anchoring
Being heavily influenced by your starting
point (e.g., sense of entitlement)
Short-termism
Preferring small, immediate rewards to
larger, more distant ones
Inertia
Putting off decisions involving complexity,
self-doubt or inconvenience

33. 33
Economic growth is currently the government’s
number one priority
In his address to the Top 200 Civil
Servants recently, the Prime
Minister said:
“I have two priorities at the
moment: the economy, and
everything else”

34. 34
Advising government is a privilege and a
responsibility requiring careful judgement
One view of success criteria for policy advice in government
Most of the time, data and
analysis do not provide a
clear-cut “answer” – but the
experts’ best judgement is
(very considerably) better
than nothing and it is their
responsibility to try to make
it relevant, heard and acted
upon, as far as possible

35. Using cost-benefit analysis in
policy making
18 November 2013
Tera Allas
Director General, Strategic Advice
Department for Business, Innovation and Skills

36. 36
Cost-benefit analysis typically follows a set of
sequential, but iterative, steps
Typical activities in performing cost-benefit analysis
1.
2.
3.
4.
5.
6.
7.
8.
9.
Set objectives and decision criteria
Identify a realistic set of options
Identify and value the costs of each option
Identify and value the benefits of each option
Adjust for distributional impacts and 2nd order impacts
(e.g., relative prices)
Discount using social time preference rate
Adjust for material tax differences
Adjust for risk and optimism
Consider unvalued costs and benefits

37. 37
Meeting the PM’s challenge requires policy makers
to understand what drives growth
Labour
participation
Hours worked
per capita
GDP per capita
£ ‘000
GDP
£ billion
x
Population
m
x
Labour
productivity
£ GVA* per
hour worked
First-order drivers**
include:
•
•
•
•
•
•
•
•
•
•
Aggregate demand
Incentives to work
Cost of labour
Labour market
efficiency
Skills
Competition
Trade
Enterprise
Innovation
Investment
* GVA=Gross Value Added; value of outputs (price times quantity) minus value of inputs; when aggregated up across sectors and adjusted for taxes and
subsidies, adds up to total GDP [GDP = GVA + taxes on products/services – subsidies on products/services]
** Many of the drivers are interconnected (e.g., enterprise drives innovation; trade drives competition) and are themselves driven by other factors (e.g.,
investment is driven by business environment, including interest rates, taxes, regulataory environment, planning system, etc.)

38. 38
Policy makers should also know key economic
concepts relevant to their work
Example list of key economic concepts everyone should know
•
•
•
•
•
•
•
•
•
Marginal costs and benefits
Opportunity cost
Counterfactual
Net present value (NPV)
Market failure
Externalities
Incentives (rational choice)
Supply and demand dynamics
Creative destruction (competition)