Ajit K. Dasgupta

The Social Rate of Discount

Whether the NPV, IRR or TV approach is adopted, a rate of discount (or rate of compound in the TV case) is required. There is a presumption that all benefits and costs, regardless of their nature, are to be discounted at the same rate, and that this rate is constant over time. Arguments can be advanced against both assumptions, but we proceed on this basis for the moment.

Internal Balance and External Balance

The discussion of Chapters 6 and 7 (see in particular sections 6.2 and 7.2) shows that a change in aggregate demand has consequences both for internal balance and for external balance. As regards the internal consequences, what emerges from these chapters is that a reduction in aggregate demand tends to drive the economy towards balance when demand is excess and away from balance when demand is deficient. Conversely, an increase in aggregate demand means a movement towards balance when demand is deficient and a movement away from balance when demand is excess. The external consequences of changes in aggregate demand arise from the short-run link between aggregate demand and real imports. A reduction in aggregate demand induces a fall in the quantity of imports (a movement down the short-run import function) ; and, given all the other elements in the external situation, this means a movement towards short-run external balance if international reserves are decreasing and away from balance if they are increasing. Conversely, an increase in aggregate demand induces a short-run increase in real imports and a movement towards external balance if the reserves are increasing and away from balance if they are decreasing.

The Damodar Valley Flood Control Scheme

The last chapter studied the application of cost-benefit analysis to the choice of site for a particular project. The present chapter is concerned with evaluating a project which is already in operation.

Utility, Costs and Benefits

The basic idea of cost-benefit analysis is simple. To decide on the worth of a project involving public expenditure (or, more extensively, public policy) it is necessary to weigh up the advantages and disadvantages. The province of cost-benefit is usually confined to public projects because the advantages and disadvantages are defined in terms of social gains and losses. It is assumed, correctly one suspects, that most private decisions are not concerned with the wider social effects, but with the effects on profits, sales or producer status.

Formulae for Project Choice

So far, it has been shown that cost-benefit analysis proceeds on the explicit basis that a project or policy be deemed socially worth while if its benefits exceed the costs it generates. The appropriate formula for expressing the social worth of a project has not been discussed in detail, nor have guidelines been offered for assisting with the choice between alternative projects. Lastly, constraints on the objective function have not been incorporated.1 This chapter looks in some detail at each of these problems, with the major assumption that costs and benefits are known with certainty. Chapter 8 relaxes the latter assumption.

The Siting of London’s Third Airport

London is already served by two airports, at Heathrow and Gatwick. In December 1970 a Government-appointed Commission, under the chairmanship of Mr Justice Roskill, recommended that a third airport should be built at Cublington in Buckinghamshire, some 45 miles from the centre of London (see Fig. 9.0.1), and that the first of the airport’s proposed four runways should be built in 1980. The recommendation was the outcome of a lengthy inquiry into a number of possible sites, of which four were short-listed for detailed analysis. Of the seven members of the Commission, only one, Professor Colin Buchanan, dissented from the majority view.1

External Effects and Public Goods

It should be evident by now that CBA differs from a ‘commercial’ appraisal of a project or policy in that it attempts to embrace all costs and benefits, whether they accrue to the investing agency or not. A basic difference between commercial and social returns consists of the ‘external’ effects of the investment; hence the importance of these effects for CBA.1

Pareto Optimality, Compensation Tests and ‘Equity’

Chapter 1 implied that CBA enabled the decision-maker to choose outcomes which are socially ‘most preferred’, no complete allowance being made for differing intensities of preference between individuals. It follows that there must be some overall state of the economy which is most preferred, and that the objective of CBA can be reformulated as that of guiding choices such that this most preferred state, or ‘social optimum’, is achieved. Clearly, this objective could only be fulfilled if (a) CBA criteria were extended to all decision contexts; (b) CBA criteria were rigidly applied — i.e. information was such that the rules were capable of universal and precise application; (c) society rested content with a concept of an optimum based on revealed preferences.

The Inflationary Process : Market-Clearing Approach

We come now to the third of our four objectives, the objective of price stability. This was defined in Chapter 1 in a negative way as absence of a persistent upward movement in some appropriate price index. Our ultimate aim in this chapter and the next two is to consider what steps the British authorities can take to promote price stability in this sense. Before we can do this, however, we must clearly have some explanation of how the persistent upward movements in the price level, which constitute absence of price stability, actually come about. One explanation of this phenomenon will be examined in the present chapter and an alternative explanation, which seems more satisfactory for the British economy, in the next. Both of these explanations are strictly short-run in character, i.e. they purport to account for a continuous upward movement in the chosen price index short period by short period (say, month by month or quarter by quarter) over a short reaction interval (say, two or three years), rather than, say, year by year over twenty years (see section 2.2).

The Consumption Function

This chapter and the following three will be theoretical in character. Our aim in these chapters will be to expound the theoretical work on dynamic, short-run macro-relationships which has been done in recent years in the spirit of Keynes, and to give an account of the British empirical research which bears on this work. By this means we hope to provide a strong theoretical framework for the discussion of the central chapters of this part of the book, namely Chapter 6 on policy in relation to the internal balance objective and Chapter 7 on policy in relation to the objective of external balance.