Economic Analysis Process

The economic analysis process consists of eigth steps:

1. Define the Objective

2. Specify Assumptions and Identify Alternatives

3. Estimate Benefits and Costs

4. Describe Intangibles

5. Compare Benefits and Costs and Rank Alternatives

6. Evaluate Variability of Benefit-Cost Estimates

7. Evaluate Distributional Impacts

8. Make Recommendations

The analytical considerations involved in each of these steps are described as follows.

STEP 1 - DEFINE THE OBJECTIVE

The analysis cannot proceed until the exact objectives of the project or regulation under consideration are precisely stated. Moreover, any project or regulation actually undertaken without a clear understanding of the desired outcome is likely to be inefficient and, perhaps, unnecessary.

The objective should be stated in terms of desired outputs of the project. It is a common failing to describe an action in terms of the inputs required to accomplish it. In some situations the objective will be specified by external authority. For example, either the executive or legislature may mandate that a particular objective be pursued. The analyst's role in such a case is limited to formulating a succinct statement of the mandated objective and clarifying ambiguities that may be present in it.

At times, several projects may be combined for management purposes. For analytical purposes, they should be separated and independently evaluated to the extent that their objectives are functionally separate. Functionally separate objectives are those which are independent of each other and do not depend upon common investments.

STEP 2 - SPECIFY ASSUMPTIONS AND IDENTIFY ALTERNATIVES

Analysis of projects which will have most of their impact in future years involves a substantial amount uncertainty. In order to proceed, assumptions must frequently be made.

There are normally several ways to achieve an end. It is important to identify all reasonable ways to achieve the desired objectives. This step is critical because only those alternatives that are identified will be evaluated. Any alternatives that exist but are not identified cannot be selected as the most efficient method to achieve the objective. In the absence of a sufficiently low cost alternative, the analysis that follows may determine that the objective is not worth undertaking since its costs exceed its benefits.

This step should not be interpreted to require that every conceivable alternative way of doing something needs to be included in the analysis. Many technically possible alternatives may be ruled out from the beginning as inferior to others which are being considered. This may occur in several situations.

First, it may be well known that a particular approach is more costly than others, at least for the scale of activity under consideration.

Second, it must be recognized that most investments build upon existing ones. Because new investments must mesh with existing ones, many potential alternatives which do not mesh can be ruled out. Note that this exclusion criterion is not applicable when considering the adoption of a new system or unction ally separate set of a replacement for existing ones.

Finally, other cases may arise where it can be determined that one or more alternatives are inferior to the others before a formal analysis is undertaken. The analyst is cautioned that such determinations should be well founded and supportable. Moreover, while such exclusions will save analytical resources, care must be taken that viable alternatives--perhaps the best one--are not excluded at this point. In particular, the analyst must not exclude alternatives merely because a predisposition exists in favor of others arising out of causes such as past practice or external constraints such as budget or others.

Successful alternative identification requires extensive knowledge of the production process or processes which can be utilized to achieve the objective. Such information is often highly technical and not confined to any single area of expertise. As a result, it is often necessary to enlist the aid of one or more technical experts at this stage of the analysis.

STEP 3 - ESTIMATE BENEFITS AND COSTS

This step requires that the value in dollars of all quantifiable benefits and costs be estimated. With respect to benefits, it is first necessary to determine the goods and services which the project or regulation can be expected to yield. Then, the value of these goods and services must be determined.

For costs, the physical resources which the project will consume must be determined and their costs estimated.

STEP 4 - DESCRIBE INTANGIBLES

A natural follow-on to quantification of benefits and costs is the identification and description of intangibles--those things which cannot be evaluated in euro terms. Intangible considerations should be listed and described for the decision maker. If possible, a range in which a euro value could be reasonably expected to fall should be reported. Intangibles should not be neglected; it is very likely that they will be extremely important to the outcome of the analysis.

STEP 5 - COMPARE BENEFITS AND COSTS AND RANK ALTERNATIVES

It is this step that provides answers to the economic questions of what objectives to pursue and how most efficiently to obtain them. It establishes whether or not benefits exceed costs for any or all of the alternatives, thus indicating whether or not the objectives should be undertaken. In addition, by providing a ranking of the alternatives it identifies which is the most efficient in achieving the objective.

STEP 6 - EVALUATE VARIABILITY OF BENEFIT AND COST ESTIMATES

Because uncertainties are always present in the benefit and cost estimates used in the comparison of alternatives, a complete picture of the situation can best be presented only if this uncertainty is explicitly considered. Techniques for doing so include sensitivity analysis, Monte Carlo simulation, and decision analysis. By utilizing these and other methods, it is possible to examine how the ranking of the alternatives under consideration holds up to changes in relevant assumptions and, given uncertainty, how likely it is that the project is or is not worth doing. In addition to helping deal with uncertainty, such analysis also provides feedback within the economic analysis process. At this stage of the analysis, it is often necessary to change key assumptions, formulate additional alternatives, and/or revise methodology. The analysis is then repeated under these new conditions. Thus, the economic analysis process becomes an iterative one.

STEP 7 - CONSIDER DISTRIBUTIONAL IMPACTS

For some investments, the recipients of the benefits are not those who bear the costs. If costs are imposed on parties who neither benefit nor are compensated, the impact will be inequitable. Benefit-cost analysis should identify gainers and losers of investments and whether gainers actually compensate losers. When benefits and costs have significant distributional effects, these should be analyzed and discussed.

STEP 8 - MAKE RECOMMENDATIONS

The final outcome of the economic analysis process is a recommendation concerning the proposed objective. Under a benefit-cost analysis there are two parts to this recommendation: should the activity be undertaken, and if so, which alternative should be selected to achieve it. For a cost effectiveness analysis, one of two answers is provided: which alternative should be selected to achieve the objective or on what activities should a fixed amount of resources (e.g., budget) be expended so as to best achieve the stated objectives.