Ecology, Policy, and Politics: Human Well-Being and the Natural World

By John O'Neill | Go to book overview

5

JUSTIFYING COST-BENEFIT ANALYSIS: ARGUMENTS FROM WELFARE

5.1 JUSTIFYING COST-BENEFIT ANALYSIS

Why should cost-benefit analysis be thought an appropriate tool of policy? The standard story begins with neo-classical economics and the efficiency of ‘ideal markets’. Cost-benefit analysis is introduced to resolve problems that arise from the departure of real markets from ‘ideal’ conditions. The story runs as follows.

A fundamental theorem of neo-classical economics is that ideal markets yield Pareto-optimal outcomes. 1 A state S1, is Pareto-optimal if there is no other state S2 such that one person prefers S2 to S1 and no one prefers S1 to S2. An ideal market is one which satisfies the following conditions: (1) Individuals have available to them at no cost full information about the quality of all goods and services and the costs of all alternative ways of producing them. 2 (2) Costs of enforcing contracts and property rights are zero. (3) Individuals are rational in the sense that their preference orderings are transitive (i.e., if an individual prefers A to B and B to C, she prefers A to C). 3 (4) Transaction costs—for example the costs of bringing goods to the market, and of formulating and agreeing contracts, are zero. (5) The market is perfectly competitive. There are no externalities, i.e. third-party effects on the satisfaction or dissatisfaction of individuals’ preferences that are not taken into account in market exchanges e.g. the benefits to others of an unspoiled landscape (positive externality) or the cost to others of pollution from nitrates (negative externality) by a farmer. Relatedly, there are no ‘public goods’—that is goods such that (a) the action of some or all of a group is a necessary and sufficient condition for the existence of a good, action by one or a few is insufficient, (b) such action is a cost to the contributing

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