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 / Spring 2008 / Issue 50(originally published by Booz & Company)


The Myth of Cost-Benefit Analysis

Economic analyses that downplay innovation do more harm than simply presenting a false, frozen-in-time reality in which business costs are unaffected by new technology and processes. As regulations themselves have often driven innovations that positively affect the economy as a whole, they smack of anti-competitiveness as well. “Once there is a rule, or threat of a rule, the incentives change,” the Ruttenberg study notes. “Regulatory cost analyses do not offset the economic benefits from vibrant new businesses and jobs that emerge...[involving products] from safety shoes to catalytic converters, from wastewater treatment chemicals to process safety management software.” In the context of one of its own regulatory decisions, OSHA even admitted that “this tendency toward overestimation of costs and underestimation of benefits allows decisions to be biased on the side of the current economic situation.”

And although their stance is antiregulatory, Hahn and Tetlock voice concerns similar to Ruttenberg’s when they note the “frequent failure” of analyses to quantify alternatives as well as benefits. They cite a 2004 study that examined whether the EPA used all available information to develop its cost-benefit analyses. “Of the 60 [regulatory impact analyses] that monetized at least some costs and considered at least one alternative, 11 did not monetize at least some costs of alternatives,” the authors write.

Another recent example of this issue is proposed legislation about fuel economy standards. In 2007, the Senate’s Ten-in-Ten Fuel Economy Act introduced mandatory cost-benefit analysis into the National Highway Traffic Safety Administration’s standard-setting process. The agency would be compelled to consider a variety of factors in determining a rule’s cost, including national security and greenhouse gas emissions. But the agency then provides no indication of or guidelines about how an intangible such as national security should be quantified for inclusion in the analysis. Costs to human health, the economy, and the environment resulting from greenhouse gas emissions are likewise left to the imagination of the analyst, who may choose to ignore such costs entirely.

There are also general economic benefits that most cost-benefit analyses ignore altogether, because the analytical gauge is too narrow. “Government economists aren’t concerned with what really happens in the economy when regulations are estimated,” says Adam Finkel, a former OSHA administrator who is now professor of environmental and occupational health at the University of Medicine and Dentistry of the New Jersey School of Public Health. “They care about the first-order effects — that the polluters will have to spend money. But this isn’t the right question. Money that’s spent to comply with an environmental regulation employs people and produces revenue for other firms. The effect on the economy is much more complicated.”

Appropriate Evaluation
Can cost-benefit analysis ever provide the basis for credible regulatory oversight? Of course it can, provided that we redesign the way it is managed and the context in which it is used. Cost-benefit analysis can be an effective tool to analyze simple, one-dimensional problems, such as whether to install dividers on dangerous stretches of highway, where relatively unambiguous data is in abundant supply and there is little controversy. It also is a good way to elucidate the trade-offs for a given policy or regulation, or to produce a summary statistic about its economic efficiency.

But the cost-benefit method loses its authority when it’s used to assess more complex decisions. It is inadequate for evaluations of interventions that will affect many different dimensions, such as markets, economies, health, the environment, and endangered species. Cost-benefit analysis is also inappropriate for products or processes over which there are disagreements about benefits or about which outcomes are important, such as new medical technologies like genetic testing. And it should never be used as the basis for regulation in the presence of scientific uncertainty or value conflicts, or in an area where there are no authorities one can trust to know all the answers, as is the case with biotechnologies such as genetic engineering and stem cell research. Decisions like these require a more expansive methodology — one that isn’t dependent on the affectation of translating all value into economic terms, that is more transparent and responsive to outside criticism, and that pragmatically represents the interests of everyone involved: industry, government, and the public.

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