In this article we will discuss about the cost-benefit analysis in economics.
Capital is not the only scarce resource, even in an LDC. Yet, the exclusive use of the ICOR, a means of selecting, which projects to fund implies that capital alone is scarce.
Other resources are scarce as well. Each good has an opportunity cost. In truth, all goods (or services) with positive prices are scarce in a market system. The point is that their scarcity can be measured by their alternatives foregone : using labour to build a bridge means that an irrigation ditch remains un-built; using land to grow paddy means that it cannot be used to grow wheat; and so on.
So, a more adequate and effective investment criterion should allow for the scarcity of all factors of production in leading to decisions about which activities should be emphasised in the developmental process.
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The resource-allocation technique by which all factor inputs can be properly evaluated is known as cost-benefit analysis (henceforth CBA). Quite recently this allocative technique has been extensively used by governments and public sector authorities all over the world. CBA provides the potential for systematic investment decision making.
It does not, however, guarantee that feasible investment projects will be made in reality. The moot point is that “as a means for systematic investment projects and for the comparison of otherwise seemingly unrelated projects and their net productivity to society, cost-benefit analysis represents a tool of incomparable value.”
Here, we just spell out the bare elements in the cost-benefit analytical process. Consider a simple situation where the present value of the future stream of benefits (V) for a project, the present value of the costs of factors other than capital (C), and the capital necessary for the project (K). For small projects the marginal productivity of capital is V – C/K.
Using the marginal productivity of capital (rather than the capital-output ratio) an investment criterion at least allows quantitatively for the scarcity of the complementary factors of production.
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One further variant of CBA takes into account the future savings and capital formation that occur as the result of the inclusion of a particular project in an overall development plan. Different projects have different effects not only on the generation of total output and income but on the distribution of that income as well. There are various recipients of income generated by a project having differing marginal propensity to save.
The conclusion that emerges is that other things being equal, those projects should be chosen which are supposed to distribute their benefits more heavily in favour of capital-owners.
The shortcomings of such a policy recommendation may now be explored:
“Redistribution of income through project choice emphasising greater capital intensity and higher savings has so many possibilities for diversion of resources that our skepticism of its wisdom has purely economic justification. If we add the political considerations implied in a regressive redistribution of income, it seems a deficient investment criterion at best.”