Cost-Benefit Analysis is a decision-making tool used to evaluate whether the benefits of an action outweigh its costs. It applies to individuals, businesses, and governments to make rational choices. This practice of comparing the marginal differences in costs and benefits is essential to economics and further explored in 1.6 β Marginal Analysis and Consumer Choice. Marginal analysis is also fundamental to decision-making, as we learn in 3.6 β Short-Run and Long-Run Decision-Making.
- Costs vs. Benefits:
- Cost: The value of what is given up (monetary, time, or opportunity cost).
- Benefit: The value or satisfaction gained from an action.
- Net Benefit:
- Decision-making focuses on maximizing the difference between total benefits and total costs.
- Opportunity Cost:
- Every choice involves trade-offs. The true cost of any action includes the next-best alternative foregone.
- Rational Decision-Making:
- Individuals and firms make choices that maximize their utility or profit by comparing marginal benefits and marginal costs.
Applications
For consumers, it would be something like choosing between spending $10 on a movie ticket or a meal, based on which provides more satisfaction.
For business, it would be something like deciding whether to invest in new machinery by comparing the cost of the investment to expected increases in revenue.
For governments, it would be something like evaluating whether building a public park is worth the cost by analyzing its impact on community well-being and local economy.
Limitations of Cost-Benefit Analysis
- Difficult to Measure Intangible Benefits:
- Example: Emotional satisfaction or social impact may be hard to quantify.
- Uncertainty:
- Future costs and benefits may be unpredictable, leading to inaccurate conclusions.
- Subjectivity:
- Different stakeholders may value costs and benefits differently, leading to conflict.