Limitations of Cost-Benefit Analysis

While CBA continues to be a primary tool for economic evaluation, adequate use of the tool requires a clear understanding of its limitations and pitfalls. It is important to keep in mind that CBA should not be used to set the ends of policy, but it may be used to set the most cost effective means of implementing the predetermined policy.

        Major limitations of CBA are:

  • Market Imperfections

Cost-benefit analysis works best in a regime of perfectly competitive markets with a large number of sellers and buyers none of whom are in a position to dominate the market. But this condition is hardly met in actual practice. There are monopolies and there are governments whose interventions distort the market further. Hence, market prices need to be adjusted before these can be used for CBA.

  • Quantification of Intangibles

Attempts made to measure items of value that are generally unmeasurable remain approximations and cannot be a perfect representation of the true value. The use of value judgements and assumptions becomes unavoidable. Thus, the quantification of intangibles is particularly susceptible to manipulation.

  • Income Distribution

Economic analysis is practiced to determine economic efficiency. Efficiency is measured without regard to who would get the benefits and who would incur the costs. Questions related to distribution of income are not taken up for consideration.

One way in which distributional aspects can be integrated into CBA is by assigning weights to benefits received and costs borne by different socio-economic groups, e.g. giving higher weight to the poorer categories. Another way of handling the distributional aspect is to establish distributional constraint as an additional criterion.

  • Discount Rate and Intergenerational Equity

Traditional CBA tends to give little weight to costs that occur far in the future and overly emphasize short-term gain. This is because a high discount rate tends to give a lower value to benefits which accrue after longer periods. It does the same for the negative effects that may arise in the distant future. It is therefore important that inter-temporal equity issues form an integral part of each decision-making process.


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