What are the limitations of cost-benefit analysis?

Limitations of cost-benefit analysis

These are some limitations that may arise in cost-benefit analysis of measuring the present and future benefits from a project and costs incurred in obtaining these benefits:

Difficulties in Cost-Assessment. Cost assessment of project is however comparatively easy than benefit assessment. Cost estimates are made on the basis of the choice of techniques, locations and prices of factor services used.

But market prices, particularly those of factors of production, from an imperfect guide to resource allocation in underdeveloped economies, because there exist fundamental disequilibria which are reflected in the existence of massive underemployment at present level of wages; the deficiency of funds at prevailing interest rates and the shortage of foreign exchange at current rates of exchange.

The equilibrium level of wage rates will be considerably lower than market wages, while equilibrium interest rates will probably be much higher than market rates. To remove these difficulties, the use of "shadow" or "accounting" prices has been suggested by J. Tinbergen and H.B. Chenery and K.S. Kretchmer.

These "shadow prices" reflect intrinsic values of factors of production. Like shadow prices, the concept of "shadow costs" has also been introduced to calculate the real costs of a particular project to society. Nowadays economists use shadow prices costs in evaluating projects and determining which are worth undertaking and which are not.

Difficulties in Benefit Assessment. The assessment of benefits is, however, still more difficult due to the presence of the element of uncertainty in a new project as to the correct estimation of future price, demand and supply of its product. Another difficulty of measuring the benefit is the assessment of external economies.

If the presence of external economies leads' to the selling of the product at marginal costs rather than at average costs, a deficit will accrue. Efforts to cover this deficit through a levy on the consumer or the government budget make the assessment of benefits vaguer.

Thus according to Professor Lewis, "To calculate the true net social benefit of an investment calls for skepticism as well as skill. The figures submitted to governments almost always involve exaggerated optimism and double counting.

If one uses low shadow wage in valuing labour, when calculating costs, one must not also, when calculating benefits, give extra credit to the project because it will relieve unemployment. Shadow pricing may be applied to costs or to benefits; the same item should not appear in both. Again annual values and capital values should not be added together." But it is difficult to predict changes in shadow prices arising from the benefits of a project.

The application of shadow prices might favour quick-yielding, labour- intensive, capital and import-light projects thereby undermining the establishment of long-term development projects.

Arbitrary Discount Rate. The assumed social rate of discount for any project is likely to be arbitrary. If an arbitrarily large discount rate is applied to calculate the net present value of benefits, it is not possible to effectively calculate the long-run results of a project. This equally applies to the internal rate of return of a project.

Neglects Joint Benefits and Costs. The above analysis of cost-benefit ignores the problems of joint benefits and joint costs arising from a project. We have seen above that a number of direct and indirect benefits flow from-a river valley project. It is difficult to evaluate and calculate such benefits separately. Similarly, they involve joint costs which cannot be separated and hence calculated benefit- wise.

Ignores Opportunity Costs. The cost-benefit analysis also ignores the problem of opportunity cost. Griffin and Enos have found a way out when they state that if all prices reflected opportunity costs, all projects for which B/C < 1 would be chosen.

The problem of adjustment for risk and uncertainty involved in the project also arises. This is done in three ways: at the time of calculating the length of project life, the discount rate, and by making due allowance in benefits and costs.

It is better to use the Government borrowing rate. The Research Programme Committee of the Indian Planning Commission suggests 5 percent as the productivity rate and 10 per cent as capital scarcity rate.

The side effects of a project are difficult to calculate in this analysis. There may be technological and pecuniary spill over's (or externalities) of a river valley project, such as the effects of flood control measures or a storage dam on the productivity of land at other places in the vicinity. It is difficult to calculate such external effects of a project.