Benefit-Cost Analysis

Introduction

So far in this book it has been assumed that undertaking a proposed project would have no effect on the market prices of goods and services. However, since the market economy consists of a complex network of inter-related output and input markets, it is possible, in principle, that undertaking the project will have wide-ranging effects on market prices. If the project's output or input quantities are small relative to the amounts traded in the markets for these goods and services, the effects on market prices will be small enough to be ignored, on the grounds that including them would have no bearing on the outcome of the analysis. While this “small project assumption” is a reasonable one for many of the projects which the analyst will encounter, it is necessary to be able to identify circumstances in which price changes are relevant, and to know how to deal with them in the benefit-cost analysis.

A project increases the aggregate supply of the output produced by the project, and increases the aggregate demand for the inputs used in the project. Significant changes in market supply or demand can result in changes in market prices. A significant change in supply or demand is one that is large relative to the quantity that would be bought and sold in the market in the absence of the project being undertaken. It is evident that there is little chance of such a change occurring where the output or input in question is traded on international markets, as will be discussed in Chapter 8.