Money, Banks and Finance in Economic Thought

Externalities and social cost-benefit analysis in economic thought and beyond

Tieben Bert, SEO Amsterdam Economics

This paper investigates the conceptualization and operationalization of external effects in social cost-benefit analysis. It is evident that the concept of external effects forms an important part of welfare economics. Social cost-benefit analysis can be seen as a practical application of welfare economics. Moreover, the presence of external effects is the main rationale for social cost benefit analysis, as non-external effects are already considered in private choices. Hence it interesting to study how theory and application merge with regard to the role external effects. It is our intention to approach this question from a historical perspective, focusing on our experience with social cost-benefit analysis in the Netherlands as a case study. In the US Eckstein (1958) expanded the scope of welfare economics to several sector of public policy via the application of cost-benefit analysis (CBA). CBA’s were subsequently applied to sectors like water resources, recreation and land conservation in the US and underground transport in the UK (Foster and Beesley 1963). Wolfson (1964) is an example of how Dutch economists joined this development. This article reviews the international literature on external effects and CBA’s and presents an early application of CBA in the Netherlands, discussing the regulation of inner city road transport. This article reviews the development of Dutch CBA practice with regard to the role external effects played in these studies. The policy document of the Netherlands Bureau of Economic Policy Analysis (once founded by Jan Tinbergen) of 2000 presents a turning point in our story (Eijgenraam e.a. 2000). This document presented a guideline for CBA’s that gained official status: investment in road infrastructure required support from a CBA according to the format of Eijgenraam e.a (2000). This guideline was subsequently further developed and refined, and applied to other policy fields. One of the main challenges is to include external effects lacking ‘hard evidence’ in the calculation. For example the social cost of curtailing CO2 emissions can be estimated on the basis of different methodologies and even for a specific methodology the degree of uncertainty is large. One of the specific issues for our paper is how CBA’s deal with the uncertainty of these ‘soft’ external effects and what the impact is of this development for the conceptualization of external effects. This approach corresponds to Krupp’s view who stated that “Externalities are not simply observables … They reflect conceptual difficulties at the boundaries of economic theory.” (quoted in Wolfson 1964, p. 661).

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Keywords: Social cost-benefit analysis, environmental economics, external effects, welfare economics, Dutch economic thought

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