Economics 9708/31 — October/November 2020

Background Concept

Cost-benefit analysis (CBA) is a systematic process used to evaluate the desirability of a project or policy by weighing its total expected costs against its total expected benefits. Crucially, CBA takes a social perspective, meaning it considers all costs and benefits to society as a whole, not just those that accrue to a private firm or individual. This includes both private costs/benefits and external costs/benefits (externalities). The core decision rule in CBA is to proceed with a project if its total social benefits exceed its total social costs, i.e., if it yields a positive net social benefit. When choosing between multiple projects, the one with the highest net social benefit is preferred. This is fundamentally different from a private firm's profit-maximising calculation, which only considers private costs and revenues.

Understanding the Question

This is a multiple-choice question asking for the main aim of cost-benefit analysis. It tests your understanding of the fundamental purpose of this tool. The four options present different possible aims. You need to select the one that accurately and completely describes the objective of CBA. The key is to recognise that CBA is a social appraisal tool, not a private one, and that its goal is to maximise the net benefit to society, not just to equate costs and benefits or to achieve a specific private objective.

Approach

1. Recall the definition and purpose of cost-benefit analysis.
2. Evaluate each option against this definition.
3. Eliminate options that describe private objectives, incomplete objectives, or specific policy tools rather than the main aim.
4. Select the option that correctly states the aim of maximising the net social benefit.

Step-by-Step Reasoning

Let's evaluate each option:

• Option A: "to allow firms to maximise their private benefit and minimise the external cost". This is incorrect. CBA is not a tool for firms to maximise private benefit; that is the objective of profit maximisation. While CBA does consider external costs, its aim is not to minimise them for a firm's benefit but to account for them in a social decision. The main aim is not about a firm's private gain.

• Option B: "to equate total social benefit to the total social cost of a project". This is a common misunderstanding. Equating total social benefit (TSB) and total social cost (TSC) would mean the net social benefit is zero. This is not the aim. The aim is to find projects where TSB exceeds TSC (positive net benefit) and, ideally, to choose the project that maximises this positive difference. Equating them is a break-even point, not an objective.

• Option C: "to find the correct level of direct tax to internalise the external cost of a project". This describes a specific policy tool (a Pigouvian tax) that might be informed by a CBA, but it is not the main aim of CBA itself. CBA is used to appraise the project; a tax is a separate policy that could be used to correct an externality identified by the analysis. The main aim is broader than just setting a tax rate.

• Option D: "to find the highest positive difference between total benefit and total cost". This is correct. The phrase "total benefit and total cost" in the context of CBA implicitly refers to social benefits and costs. The aim is to identify the project that yields the maximum net social benefit (Total Social Benefit - Total Social Cost). This is the core decision rule for efficient resource allocation from a societal perspective.

Key Takeaways

• The fundamental purpose of cost-benefit analysis is to appraise projects from a social perspective.
• Its main aim is to maximise net social benefit (Total Social Benefit - Total Social Cost).
• CBA is distinct from private cost-benefit calculations (profit maximisation).
• It is a tool for decision-making, not a specific policy instrument like a tax.

Common Mistakes

• Confusing the aim with a break-even point: Choosing option B because it mentions both costs and benefits. The aim is not to make them equal but to ensure benefits exceed costs by the greatest margin.
• Confusing the tool with a specific policy: Choosing option C because it relates to externalities. CBA is the analysis; a corrective tax is a potential outcome of that analysis.
• Thinking of private firms: Choosing option A because it mentions firms. CBA is primarily a public-sector tool for social appraisal.

Things to Be Careful About

• Pay close attention to the wording. "Highest positive difference" is the key phrase in option D that signals the maximisation objective.
• Remember that CBA always considers social costs and benefits, even if the option just says "total benefit and total cost".
• Do not overcomplicate the question. The main aim is a simple, fundamental concept.