The Cost-Benefit Fallacy: Why Cost-Benefit Analysis Is Broken and How to Fix It

TL;DR

This paper reveals that cost-benefit analyses of public investments are often highly inaccurate and biased, leading to distorted resource allocation, and proposes reforms to improve their reliability.

Contribution

It provides the largest empirical evidence showing the inaccuracy and bias in public investment estimates and suggests specific reforms for more effective analysis.

Findings

Widespread cost overruns and benefit shortfalls in public projects

Significant forecasting bias identified in estimates

Inaccuracies distort resource allocation decisions

Abstract

Most cost-benefit analyses assume that the estimates of costs and benefits are more or less accurate and unbiased. But what if, in reality, estimates are highly inaccurate and biased? Then the assumption that cost-benefit analysis is a rational way to improve resource allocation would be a fallacy. Based on the largest dataset of its kind, we test the assumption that cost and benefit estimates of public investments are accurate and unbiased. We find this is not the case with overwhelming statistical significance. We document the extent of cost overruns, benefit shortfalls, and forecasting bias in public investments. We further assess whether such inaccuracies seriously distort effective resource allocation, which is found to be the case. We explain our findings in behavioral terms and explore their policy implications. Finally, we conclude that cost-benefit analysis of public investments stands in need of reform and we outline four steps to such reform.