General Types of Economic Analysis

The term economic analysis is a broad one. It encompasses a spectrum of topics including economy wide analysis, regional studies, market structure investigations, and analysis of specific decisions. It is this last topic, as applied to investment, regulatory and certain grant award decisions that are the topic of this article. Such applications usually concern the addition or subtraction of a particular investment or regulation to the existing system or body of regulations--denoted as marginal or incremental analysis. For the most part, the methodology outlined is also applicable to the evaluation of a system in total or a body of regulations.

Economic analysis of investment and regulatory decisions seeks to provide answers to two economic questions: (1) is a particular objective worth achieving, and (2) which of several alternative methods of achieving an objective is best? Two general procedures are employed to answer the questions.

The first, cost effectiveness analysis, assumes that the first economic question has been answered in the affirmative and concentrates on providing an answer to the second question of which alternative is best.

The second, benefit-cost analysis, seeks to answer both questions. While benefit-cost analysis is more complete than cost-effectiveness analysis, studies are often limited to the latter because of an inability to measure benefits in euro.

A. Cost Effectiveness

There are two types of cost-effectiveness analysis: (1) least cost studies, and (2) constant cost studies.
Least cost studies are appropriate where the level of effort is undetermined and relatively unconstrained but the level of output/benefits is fixed. The procedure concentrates on identifying the least expensive way of producing a given amount of a certain output. The analysis typically begins with a statement of a required objective. Alternative methods of achieving the requirements are then defined. Costs are estimated for each alternative and the least cost alternative identified.

Least cost studies are frequently undertaken when the decision has already been made to produce a given amount of the output in question. Examples of such situations are when a requirement for the output is established by administrative or legislative direction, when the output is required to support another program which is required, or when deciding whether or not to replace existing equipment with new, cheaper-to-operate equipment which produces the same output. In all such situations, the analysis is confined to answering the question of how to produce.

Constant-cost studies are appropriate in situations where the level of output/benefits is undefined but the budget/resources available are fixed. The purpose of the analysis is to identify the outputs of each of a number of equal cost options and then decide which of the alternatives is best for producing the determined level of outputs/benefits. Such a situation typically arises where an agency is allocated a given amount of funds and directed to pursue a particular objective. The analysis permits the agency to determine how to produce the maximum amount of desired output/benefits with the given funds.

Analyses of this type require that outputs be measured in some way. If only one output is involved, the measurement can be in any convenient albeit arbitrary unit. If more than one output is involved, a unit of measurement applicable to all units is required. If no such unit can be found, the study must of necessity be confined to a description of the outputs of the various alternatives. Judgments as to the relative importance of each separate output are then left to the policymaker.

B. Benefit-Cost Analysis

Benefit-cost analysis seeks to determine whether or not a certain output shall be produced and, if so, how best to produce it. It thus goes beyond the limited objective of cost-effectiveness analysis of determining how best to produce.

Benefit-cost analysis calls for the examination of all costs related to the production and consumption of an output, whether the costs are borne by the producer, the consumer, or a third party. Similarly, the method requires an examination of all benefits resulting from the production and consumption of the output, regardless of who realizes the benefits. Because the ultimate objective of benefit-cost analysis is the comparison of benefits and costs, they both must be evaluated in the same unit of measurement. It is rare that anything other than euro (or another monetary unit) proves to be satisfactory.

The benefit-cost procedure requires that alternative methods of producing the output be identified.

The benefits of each alternative are then valued in euro and compared to their expected costs.
That alternative for which benefits exceed costs by the greatest amount is identified as the project alternative to be undertaken. The action is worth taking because benefits exceed costs. It is best because benefits exceed costs by the greatest amount. Such studies often experience no difficulty in the identification and valuation of benefits. Produced outputs are usually sold under market conditions making it possible to determine their value to consumers.