of Federal Regulations
Under Executive Order 12866
After President Clinton signed Executive Order 12866, "Regulatory Planning
and Review," the Administrator of the Office of Information and Regulatory
Affairs of the Office of Management and Budget convened an interagency
group to review the state of the art for economic analyses of regulatory
actions required by the Executive Order. The group was co-chaired by a
Member of the Council of Economic Advisers and included representatives
of all the major regulatory agencies. This document represents the results
of an exhaustive two-year effort by the group to describe "best practices"
for preparing the economic analysis of a significant regulatory action
called for by the Executive Order.
Table of Contents
I. STATEMENT OF NEED FOR THE PROPOSED ACTION
or Asymmetric Information
of Non-Federal Regulation
II. AN EXAMINATION OF ALTERNTIVE APPROACHES
- More Performance-Oriented
for Health, Safety, and Environmental Regulations
Requirements for Different Segments of the Regulated Population
Levels of Stringency
Effective Dates of Compliance
Methods of Ensuring Compliance
- More Market-Oriented
Specific Statutory Requirements
ANALYSIS OF BENEFITS AND COSTS
of Risk and Uncertainty
Valuing risk levels and changes
Benefits and Costs
Effects and Equity
for Valuing Benefits Directly Traded in Markets
for Valuing Benefits Indirectly Traded in Markets
for Valuing Benefits That Are Not Traded Directly or Indirectly
for Valuing Health and Safety Effects
Nonfatal illness and injury
Alternative methodological frameworks for estimating benefits
from reduced fatality risks
Costs Versus Transfer Payments
Scarcity rents and monopoly profits
Indirect taxes and subsidies
SELECTED FURTHER READINGS
OF FEDERAL REGULATIONS
UNDER EXECUTIVE ORDER 12866
with the regulatory philosophy and principles provided in Sections 1(a)
and (b) and Section 6(a)(3)(C) of Executive Order 12866, an Economic Analysis
(EA) of proposed or existing regulations should inform decisionmakers of
the consequences of alternative actions. In particular, the EA should provide
information allowing decisionmakers to determine that:
There is adequate information indicating the need for and consequences
of the proposed action;
benefits to society justify the potential costs, recognizing that not
all benefits and costs can be described in monetary or even in quantitative
terms, unless a statute requires another regulatory approach;
action will maximize net benefits to society (including potential economic,
environmental, public health and safety, and other advantages; distributional
impacts; and equity), unless a statute requires another regulatory approach;
a statute requires a specific regulatory approach, the proposed action
will be the most cost-effective, including reliance on performance objectives
to the extent feasible;
decisions are based on the best reasonably obtainable scientific, technical,
economic, and other information.
EAs should include these elements, variations consistent with the spirit
and intent of the Executive Order may be warranted for some regulatory
actions. In particular, regulations establishing terms or conditions of
Federal grants, contracts, or financial assistance may call for a different
form of regulatory analysis, although a full-blown benefit-cost analysis
of the entire program may be appropriate to inform Congress and the President
more fully about its desirability.
The EA that
the agency prepares should also satisfy the requirements of the "Unfunded
Mandates Reform Act of 1995" (P.L. 104-4). Title II of this statute (Section
201) directs agencies "unless otherwise prohibited by law [to] assess
the effects of Federal regulatory actions on State, local, and tribal
governments, and the private sector..." Section 202(a) directs agencies
to provide a qualitative and quantitative assessment of the anticipated
costs and benefits of a Federal mandate resulting in annual expenditures
of $100 million or more, including the costs and benefits to State, local,
and tribal governments or the private sector. Section 205(a) requires
that for those regulations for which an agency prepares a statement under
Section 202, "the agency shall  identify and consider a reasonable
number of regulatory alternatives and  from those alternatives select
the least costly, most cost-effective or least burdensome alternative
that achieves the objectives of the proposed rule." If the agency does
not select "the least costly, most cost-effective, or least burdensome
option, and if the requirements of Section 205(a) are not "inconsistent
with law," Section 205(b) requires that the agency head publish "with
the final rule an explanation of why the least costly, most cost-effective,
or least burdensome method was not adopted."
Flexibility Act" (P.L. 96-354) requires Federal agencies to give special
consideration to the impact of regulation on small businesses. The Act
specifies that a regulatory flexibility analysis must be prepared if a
screening analysis indicates that a regulation will have a significant
impact on a substantial number of small entities. The EA that the agency
prepares should incorporate the regulatory flexibility analysis, as appropriate.
is not in the form of a mechanistic blueprint, for a good EA cannot be
written according to a formula. Competent professional judgment is indispensable
for the preparation of a high-quality analysis. Different regulations
may call for very different emphases in analysis. For one proposed regulation,
the crucial issue may be the question of whether a market failure exists,
and much of the analysis may need to be devoted to that key question.
In another case, the existence of a market failure may be obvious from
the outset, but extensive analysis might be necessary to estimate the
magnitude of benefits to be expected from proposed regulatory alternatives.
of the risks, benefits, and costs associated with regulation must be guided
by the principles of full disclosure and transparency. Data, models, inferences,
and assumptions should be identified and evaluated explicitly, together
with adequate justifications of choices made, and assessments of the effects
of these choices on the analysis. The existence of plausible alternative
models or assumptions, and their implications, should be identified. In
the absence of adequate valid data, properly identified assumptions are
necessary for conducting an assessment.
of the risks, benefits, and costs associated with regulation inevitably
also involves uncertainties and requires informed professional judgments.
There should be balance between thoroughness of analysis and practical
limits to the agency's capacity to carry out analysis. The amount of analysis
(whether scientific, statistical, or economic) that a particular issue
requires depends on the need for more thorough analysis because of the
importance and complexity of the issue, the need for expedition, the nature
of the statutory language and the extent of statutory discretion, and
the sensitivity of net benefits to the choice of regulatory alternatives.
In particular, a less detailed or intensive analysis of the entire range
of regulatory options is needed when regulatory options are limited by
statute. Even in these cases, however, agencies should provide some analysis
of other regulatory options that satisfy the philosophy and principles
of the Executive Order, in order to provide decisionmakers with information
for judging the consequences of the statutory constraints. Whenever an
agency has questions about such issues as the appropriate analytical techniques
to use or the alternatives that should be considered in developing an
EA under the Executive Order, it should consult with the Office of Management
and Budget as early in the analysis stage as possible.
and final Economic Analyses of economically "significant " rules ( as
defined in Section 3(f)(1) of the Executive Order) should contain three
elements: (1) a statement of the need for the proposed action, (2) an
examination of alternative approaches, and (3) an analysis of benefits
and costs. These elements are described in Sections I-III below. The same
basic analytical principles apply to the review of existing regulations,
as called for under Section 5 of the Executive Order. In this case, the
regulation under review should be compared to a baseline case of not taking
the regulatory action and to reasonable alternatives.
I. STATEMENT OF
NEED FOR THE PROPOSED ACTION
to establish the need for the proposed action, the analysis should discuss
whether the problem constitutes a significant market failure. If the problem
does not constitute a market failure, the analysis should provide an alternative
demonstration of compelling public need, such as improving governmental
processes or addressing distributional concerns. If the proposed action
is a result of a statutory or judicial directive, that should be so stated.
should determine whether there exists a market failure that is likely
to be significant. In particular, the analysis should distinguish actual
market failures from potential market failures that can be resolved at
relatively low cost by market participants. Examples of the latter include
spillover effects that affected parties can effectively internalize by
negotiation, and problems resulting from information asymmetries that
can be effectively resolved by the affected parties through vertical integration.
Once a significant market failure has been identified, the analysis should
show how adequately the regulatory alternatives to be considered address
the specified market failure.
types of market failure include: externality, natural monopoly, market
power, and inadequate or asymmetric information.
An externality occurs when one party's actions impose uncompensated
benefits or costs on another. Environmental problems are a classic
case of externality. Another example is the case of common property
resources that may become congested or overused, such as fisheries
or the broadcast spectrum. A third example is a "public good," such
as defense or basic scientific research, which is distinguished by
the fact that it is inefficient, or impossible, to exclude individuals
from its benefits.
Monopoly. A natural monopoly exists where a market can be served
at lowest cost only if production is limited to a single producer.
Local gas and electricity distribution services are examples.
Power. Firms exercise market power when they reduce output below
what a competitive industry would sell. They may exercise market power
collectively or unilaterally. Government action can be a source of
market power, for example if regulatory actions exclude low-cost imports,
allowing domestic producers to raise price by reducing output.
or Asymmetric Information. Market failures may also result from
inadequate or asymmetric information. The appropriate level of information
is not necessarily perfect or full information because information,
like other goods, is costly. The market may supply less than the appropriate
level of information because it is often infeasible to exclude nonpayers
from reaping benefits from the provision of information by others. In
markets for goods and services, inadequate information can generate
a variety of social costs, including inefficiently low innovation, market
power, or inefficient resource allocation resulting from deception of
consumers. Markets may also fail to allocate resources efficiently when
some economic actors have more information than others.
other hand, the market may supply a reasonably adequate level of information.
Sellers have an incentive to provide informative advertising to increase
sales by highlighting distinctive characteristics of their products.
There are also a variety of ways in which "reputation effects" may
serve to provide adequate information. Buyers may obtain reasonably
adequate information about product characteristics even when the seller
does not provide that information, for example, if buyer search costs
are low (as when the quality of a good can be determined by inspection
at point of sale), if buyers have previously used the product, if
sellers offer warranties, or if adequate information is provided by
third parties. In addition, insurance markets are important sources
of information about risks.
action may have unintentional harmful effects on the efficiency of
market outcomes. For this reason there should be a presumption against
the need for regulatory actions that, on conceptual grounds, are not
expected to generate net benefits, except in special circumstances.
In light of actual experience, a particularly demanding burden of
proof is required to demonstrate the need for any of the following
types of regulations:
controls in competitive markets;
or sales quotas in competitive markets;
mandatory uniform quality standards for goods or services, unless
they have hidden safety hazards or other defects or involve externalities
and the problem cannot be adequately dealt with by voluntary standards
or information disclosing the hazard to potential buyers or users;
controls on entry into employment or production, except (a) where
indispensable to protect health and safety (e.g., FAA tests for
commercial pilots) or (b) to manage the use of common property
resources (e.g., fisheries, airwaves, Federal lands, and offshore
of Alternatives to Federal Regulation
a market failure exists, there may be no need for Federal regulatory intervention
if other means of dealing with the market failure would resolve the problem
adequately or better than the proposed Federal regulation would. These
alternatives may include the judicial system, antitrust enforcement, and
workers' compensation systems. Other nonregulatory alternatives could
include, for example, subsidizing actions to achieve a desired outcome;
such subsidies may be more efficient than rigid mandates. Similarly, a
fee or charge, such as an effluent discharge fee, may be a preferable
alternative to banning or restricting a product or action. Legislative
measures that make use of economic incentives, such as changes in insurance
provisions, should be considered where feasible. Modifications to existing
regulations should be considered if those regulations have created or
contributed to a problem that the new regulation is intended to correct,
and if such changes can achieve the goal more efficiently or effectively.
important factor to consider in assessing the appropriateness of a Federal
regulation is regulation at the State or local level, if such an option
is available. In some cases, the nature of the market failure may itself
suggest the most appropriate governmental level of regulation. For example,
problems that spill across State lines (such as acid rain whose precursors
are transported widely in the atmosphere) are probably best controlled
by Federal regulation, while more localized problems may be more efficiently
addressed locally. Where regulation at the Federal level appears appropriate,
for example to address interstate commerce issues, the analysis should
attempt to determine whether the burdens on interstate commerce arising
from different State and local regulations, including the compliance costs
imposed on national firms, are greater than the potential advantages of
diversity, such as improved performance from competition among governmental
units in serving taxpayers and citizens and local political choice.
II. AN EXAMINATION
OF ALTERNATIVE APPROACHES
should show that the agency has considered the most important alternative
approaches to the problem and provide the agency's reasoning for selecting
the proposed regulatory action over such alternatives. Ordinarily, it will
be possible to eliminate some alternatives by a preliminary analysis, leaving
a manageable number of alternatives to be evaluated according to the principles
of the Executive Order. The number and choice of alternatives to be selected
for detailed benefit-cost analysis is a matter of judgment. There must be
some balance between thoroughness of analysis and practical limits to the
agency's capacity to carry out analysis. With this qualifier in mind, the
agency should nevertheless explore modifications of some or all of a regulation's
attributes or provisions to identify appropriate alternatives.
regulatory actions that should be explored include the following:
Performance-Oriented Standards for Health, Safety, and Environmental
Regulations. Performance standards are generally to be preferred
to engineering or design standards because performance standards provide
the regulated parties the flexibility to achieve the regulatory objective
in a more cost-effective way. It is therefore misleading and inappropriate
to characterize a standard as a performance standard if it is set
so that there is only one feasible way to meet it; as a practical
matter, such a standard is a design standard. In general, a performance
standard should be preferred wherever that performance can be measured
or reasonably imputed. Performance standards should be applied with
a scope appropriate to the problem the regulation seeks to address.
For example, to create the greatest opportunities for the regulated
parties to achieve cost savings while meeting the regulatory objective,
compliance with air emission standards can be allowed on a plant-wide,
firm-wide, or region-wide basis rather than vent by vent, provided
this does not produce unacceptable air quality outcomes (such as "hot
spots" from local pollution concentration).
Requirements for Different Segments of the Regulated Population.
There might be different requirements established for large and small
firms, for example. If such a differentiation is made, it should be
based on perceptible differences in the costs of compliance or in
the benefits to be expected from compliance. It is not efficient to
place a heavier burden on one segment of the regulated population
solely on the grounds that it is better able to afford the higher
cost; this has the potential to load on the most productive sectors
of the economy costs that are disproportionate to the damages they
Levels of Stringency. In general, both the benefits and costs
associated with a regulation will increase with the level of stringency
(although marginal costs generally increase with stringency, whereas
marginal benefits decrease). It is important to consider alternative
levels of stringency to better understand the relationship between
stringency and the size and distribution of benefits and costs among
Effective Dates of Compliance. The timing of a regulation may
also have an important effect on its net benefits. For example, costs
of a regulation may vary substantially with different compliance dates
for an industry that requires a year or more to plan its production
runs efficiently. In this instance, a regulation that provides sufficient
lead time is likely to achieve its goals at a much lower overall cost
than a regulation that is effective immediately, although the benefits
also could be lower.
Methods of Ensuring Compliance. Compliance alternatives for Federal,
state, or local enforcement include on-site inspection, periodic reporting,
and compliance penalties structured to provide the most appropriate
incentives. When alternative monitoring and reporting methods vary
in their costs and benefits, promising alternatives should be considered
in identifying the regulatory alternative that maximizes net benefits.
For example, in some circumstances random monitoring will be less
expensive and nearly as effective as continuous monitoring in achieving
Measures. Measures to improve the availability of information
include government establishment of a standardized testing and rating
system (the use of which could be made mandatory or left voluntary),
mandatory disclosure requirements (e.g., by advertising, labeling,
or enclosures), and government provision of information (e.g., by
government publications, telephone hotlines, or public interest broadcast
announcements). If intervention is necessary to address a market failure
arising from inadequate or asymmetric information, informational remedies
will often be the preferred approaches. As an alternative to a mandatory
product standard or ban, a regulatory measure to improve the availability
of information (particularly about the concealed characteristics of
products) gives consumers a greater choice. Incentives for information
dissemination also are provided by features of product liability law
that reduce liability or damages for firms that have provided consumers
for prohibiting indisputably false statements (whose banning can be
presumed beneficial), specific informational measures should be evaluated
in terms of their benefits and costs. The key to analyzing informational
measures is a comparison of the actions of the affected parties with
the information provided in the baseline (including any information
displaced by mandated disclosures) and the actions of affected parties
with the information requirements being imposed. Some effects of informational
measures can easily be overlooked. For example, the costs of a mandatory
disclosure requirement for a consumer product include not only the
cost of gathering and communicating the required information, but
also the loss of net benefits of any information displaced by the
mandated information, the effect of providing too much information
that is ignored or information that is misinterpreted, and inefficiencies
arising from the incentive that mandatory disclosure may give to overinvest
in a particular characteristic of a product or service.
information on the benefits and costs of alternative informational
measures is insufficient to provide a clear choice between them, as
will often be the case, the least intrusive informational alternative,
sufficient to accomplish the regulatory objective, should be considered.
For example, to correct an informational market failure it may be
sufficient for government to establish a standardized testing and
rating system without mandating its use, because competing firms that
score well according to the system will have ample incentive to publicize
Market-Oriented Approaches. In general, alternatives that provide
for more market-oriented approaches, with the use of economic incentives
replacing command-and-control requirements, are more cost-effective
and should be explored. Market-oriented alternatives that may be considered
include fees, subsidies, penalties, marketable permits or offsets,
changes in liabilities or property rights (including policies that
alter the incentive of insurers and insured parties), and required
bonds, insurance or warranties. (In many instances, implementing these
alternatives will require legislation.)
Specific Statutory Requirements. When a statute establishes a
specific regulatory requirement and the agency has discretion to adopt
a more stringent standard, the agency should examine the benefits
and costs of the specific statutory requirement as well as the more
stringent alternative and present information that justifies the more
stringent alternative if that is what the agency proposes.
III. ANALYSIS OF
BENEFITS AND COSTS
analysis described in Sections I and II will lead to the identification
of a workable number of alternatives for consideration.
The benefits and costs of each alternative must be measured against
a baseline. The baseline should be the best assessment of the way the
world would look absent the proposed regulation. That assessment may
consider a wide range of factors, including the likely evolution of
the market, likely changes in exogenous factors affecting benefits and
costs, likely changes in regulations promulgated by the agency or other
government entities, and the likely degree of compliance by regulated
entities with other regulations. Often it may be reasonable for the
agency to forecast that the world absent the regulation will resemble
the present. For the review of an existing regulation, the baseline
should be no change in existing regulation; this baseline can then be
compared against reasonable alternatives.
more than one baseline appears reasonable or the baseline is very
uncertain, and when the estimated benefits and costs of proposed rules
are likely to vary significantly with the baseline selected, the agency
may choose to measure benefits and costs against multiple alternative
baselines as a form of sensitivity analysis. For example, the agency
may choose to conduct a sensitivity analysis involving the consequences
for benefits and costs of different assumptions about likely regulation
by other governmental entities, or the degree of compliance with the
agency's own existing rules. In every case, an agency must measure
both benefits and costs against the identical baseline. The agency
should also provide an explanation of the plausibility of the alternative
baselines used in the sensitivity analysis.
of Alternatives. Agencies should identify (with an appropriate level
of analysis) alternatives that meet the criteria of the Executive Order
as summarized at the beginning of this document, as well as identifying
statutory requirements that affect the selection of a regulatory approach.
If legal constraints prevent the selection of a regulatory action that
best satisfies the philosophy and principles of the Order, these constraints
should be identified and explained, and their opportunity cost should
be estimated. To the fullest extent possible, benefits and costs should
be expressed in discounted constant dollars. Appropriate discounting
procedures are discussed in the following section.
on distributional impacts related to the alternatives should accompany
the analysis of aggregate benefits and costs. Where relevant and feasible,
agencies can also indicate how aggregate benefits and costs depend
on the incidence of benefits and costs. Agencies should present a
reasoned explanation or analysis to justify their choice among alternatives.
distinction between benefits and costs in benefit-cost analysis is
somewhat arbitrary, since a positive benefit may be considered a negative
cost, and vice versa, without affecting net benefits. This implies
that the considerations applicable to benefit estimates also apply
to cost estimates and vice versa.
among mutually exclusive alternatives, benefit-cost ratios should
be used with care. Selecting the alternative with the highest benefit-cost
ratio may not identify the best alternative, since an alternative
with a lower benefit-cost ratio than another may have higher net benefits.
In addition, the internal rate of return should not be used as a criterion
for choosing among mutually exclusive alternatives. It is often difficult
to compute and is problematical when multiple rates exist.
monetization is not possible for certain elements of the benefits
or costs that are essential to consider, other quantitative and qualitative
characterizations of these elements should be provided (see sections
7 and 8 below). Cost-effectiveness analysis also should be used where
possible to evaluate alternatives. Costs should be calculated net
of monetized benefits. Where some benefits are monetizable and others
are not, a cost-effectiveness analysis will generally not yield an
unambiguous choice; nevertheless, such an analysis is helpful for
calculating a "breakeven" value for the unmonetized benefits (i.e.,
a value that would result in the action having positive net benefits).
Such a value can be evaluated for its reasonableness in the discussion
of the justification of the proposed action. Cost-effectiveness analysis
should also be used to compare regulatory alternatives in cases where
the level of benefits is specified by statute.
proposed regulation is composed of a number of distinct provisions,
it is important to evaluate the benefits and costs of the different
provisions separately. The interaction effects between separate provisions
(such that the existence of one provision affects the benefits or
costs arising from another provision) may complicate the analysis
but does not eliminate the need to examine provisions separately.
In such a case, the desirability of a specific provision may be appraised
by determining the net benefits of the proposed regulation with and
without the provision in question. Where the number of provisions
is large and interaction effects are pervasive, it is obviously impractical
to analyze all possible combinations of provisions in this way. Some
judgment must be used to select the most significant or suspect provisions
for such analysis.
One of the problems that arises in developing a benefit-cost analysis
is that the benefits and costs often occur in different time periods.
When this occurs, it is not appropriate, when comparing benefits and
costs, to simply add up the benefits and costs accruing over time. Discounting
takes account of the fact that resources (goods or services) that are
available in a given year are worth more than the identical resources
available in a later year. One reason for this is that resources can
be invested so as to return more resources later. In addition, people
tend to be impatient and to prefer earlier consumption over later consumption.
Basic considerations. Constant-dollar benefits and costs must be
discounted to present values before benefits and costs in different
years can be added together to determine overall net benefits. To
obtain constant dollar estimates, benefit and cost streams in nominal
dollars should be adjusted to correct for inflation. The basic guidance
on discount rates for regulatory and other analyses is provided
in OMB Circular A-94. The discount rate specified in that guidance
is intended to be an approximation of the opportunity cost of capital,
which is the before-tax rate of return to incremental private investment.
The Circular A-94 rate, which was revised in 1992 based on an extensive
review and public comment, reflects the rates of return on low yielding
forms of capital, such as housing, as well as the higher rates of
returns yielded by corporate capital. This average rate currently
is estimated to be 7 percent in real terms (i.e., after adjusting
for inflation). As noted in the A-94 guidance, agencies may also
present sensitivity analyses using other discount rates, along with
a justification for the consideration of these alternative rates.
The economic analysis also should contain a schedule indicating
when all benefits and costs are expected to occur.
In general, the discount rate should not be adjusted to account
for the uncertainty of future benefits and costs. Risk and uncertainty
should be dealt with according to the principles presented in
Section 4 below and not by changing the discount rate.
Even those benefits and costs that are hard to quantify in monetary
terms should be discounted. The schedule of benefits and costs
over time therefore should include benefits that are hard to monetize.
In many instances where it is difficult to monetize benefits,
agencies conduct regulatory "cost-effectiveness" analyses instead
of "net benefits" analyses. When the effects of alternative options
are measured in units that accrue at the same time that the costs
are incurred, annualizing costs is sufficient and further discounting
of non-monetized benefits is unnecessary; for instance, the annualized
cost per ton of reducing certain polluting emissions can be an
appropriate measure of cost-effectiveness. However, when effects
are measured in units that accrue later than when the costs are
incurred, such as the reduction of adverse health effects that
occur only after a long period of exposure, the annualized cost
per unit should be calculated after discounting for the delay
between accrual of the costs and the effects.
In assessing the present value of benefits and costs from a regulation,
it may be necessary to consider implications of changing relative
prices over time. For example, increasing scarcity of certain
environmental resources could increase their value over time relative
to conventional consumer goods. In such a situation, it is inappropriate
to use current relative values for assessing regulatory impacts.
However, while taking into account changes over time in relative
values may have an effect similar to discounting environmental
impacts at a lower rate, it is important to separate the effects
of discounting from the effects of relative price changes in the
economic analysis. In particular, the discount rate should not
be adjusted for expected changes in the relative prices of goods
over time. Instead, any changes in relative prices that are anticipated
should be incorporated directly in the calculations of benefit
and cost streams.
Additional considerations. Modern research in economic theory has
established a preferred model for discounting, sometimes referred
to as the shadow price approach. The basic concept is that economic
welfare is ultimately determined by consumption; investment affects
welfare only to the extent that it affects current and future consumption.
Thus, any effect that a government program has on public or private
investment must be converted to an associated stream of effects on
consumption before being discounted.
investment-related benefits and costs to their consumption-equivalents
as required by this approach involves calculating the "shadow price
of capital." This shadow price reflects the present value of the
future changes in consumption arising from a marginal change in
investment, using the consumption rate of interest (also termed
the rate of time preference) as the discount rate. The calculation
of the shadow price of capital requires assumptions about the extent
to which government actions -- including regulations -- crowd out
private investment, the social (i.e., before-tax) returns to this
investment, and the rate of reinvestment of future yields from current
of the shadow price are quite sensitive to these assumptions. For
example, in some applications it may be appropriate to assume that
access to global capital markets implies no crowding out of private
investment by government actions or that monetary and fiscal authorities
determine aggregate levels of investment so that the impact of the
contemplated regulation on total private investment can be ignored.
Alternatively, there is evidence that domestic saving affects domestic
investment and that regulatory costs may also reduce investment.
In these cases, more substantial crowding out would be an appropriate
rate of time preference is also a complex issue. Generally, it is
viewed as being approximated by the real return to a safe asset,
such as Government debt. However, a substantial fraction of the
population does little or no saving and may borrow at relatively
high interest rates.
the shadow price approach is theoretically preferred, there are
several practical challenges to its use. Agencies wishing to use
this methodology should consult with OMB prior to doing so, and
should clearly explain their solutions to the methodological and
empirical challenges noted above.
analysis. Comparisons of benefits and costs across generations raise
special questions about equity, in addition to conventional concerns
about efficiency. One approach to these questions is to follow the
discounting procedures described above and to address equity issues
explicitly rather than through modification of the discount rate.
alternative approach is to use a special social rate of time preference
when conducting intergenerational analyses in order to properly
value changes in consumption in different generations. For example,
one philosophical perspective is that the social marginal rate of
substitution between the well-being of members of successive generations
may be less than the individual rate of time preference, and that
future generations should not have their expected welfare discounted
just because they come later in time. Instead, this view suggests
that discounting should reflect only the growth of per capita consumption
and the corresponding decrease in marginal utility over time. As
this approach uses a consumption-based rate of interest, costs and
benefits must also be adjusted to reflect the shadow price of capital.
As in other cases when agencies seek to use the shadow price of
capital approach, they should consult with OMB prior to conducting
special analyses of regulations having substantial intergenerational
of Risk and Uncertainty. The effects of regulatory actions frequently
are not known with certainty but can be predicted in terms of their
probability of occurrence. The term "risk" in this document refers generally
to a probability distribution over a set of outcomes. When the outcomes
in question are hazards or injuries, risk can be understood to refer
to the probabilities of different potential severities of hazard or
injury. For example, the risk of cancer from exposure to a chemical
means a change in the probability of contracting cancer caused by that
exposure. There also are risks associated with economic benefits and
costs, e.g., the risk of a financial loss of $X means the probability
of losing $X.
risks, benefits, and costs are measured imperfectly because key parameters
are not known precisely; instead, the economic analysis must rely
upon statistical probability distributions for the values of parameters.
Both the inherent lack of certainty about the consequences of a potential
hazard (for example, the odds of contracting cancer) and the lack
of complete knowledge about parameter values that define risk relationships
(for example, the relationship between presence of a carcinogen in
the food supply and the rate of absorption of the carcinogen) should
term "uncertainty" often is used in economic assessments as a synonym
for risk. However, in this document uncertainty refers more specifically
to the fact that knowledge of the probabilities and sets of possible
outcomes that characterize a probability distribution of risks, based
on experimentation, statistical sampling, and other scientific tools,
is itself incomplete. Thus, for example, a cancer risk might be described
as a one-in-one-thousand chance of contracting cancer after 70 years
of exposure. However, this estimate may be uncertain because individuals
vary in their levels of exposure and their sensitivity to such exposures;
the science underlying the quantification of the hazard is uncertain;
or there are plausible competitors to the model for converting scientific
knowledge and empirical measures of exposures into risk units. Estimates
of regulatory benefits entail additional uncertainties, such as the
appropriate measures for converting from units of risk to units of
value. Cost estimates also will be uncertain when there are uncertainties
in opportunity costs or the compliance strategies of regulated entities.
the benefits and costs of risk-reducing regulations includes two components:
a risk assessment that, in part, characterizes the probabilities of
occurrence of outcomes of interest; and a valuation of the levels
and changes in risk experienced by affected populations as a result
of the regulation. It is essential that both parts of such evaluations
be conceptually consistent. In particular, risk assessments should
be conducted in a way that permits their use in a more general benefit-cost
framework, just as the benefit-cost analysis should attempt to capture
the results of the risk assessment and not oversimplify the results
(e.g., the analysis should address the benefit and cost implications
of probability distributions).
management is an activity conceptually distinct from risk assessment
or valuation, involving a policy of whether and how to respond to
risks to health, safety, and the environment. The appropriate level
of protection is a policy choice rather than a scientific one. The
risk assessment should generate a credible, objective, realistic,
and scientifically balanced analysis; present information on hazard,
dose-response, and exposure (or analogous material for non-health
assessments); and explain the confidence in each assessment by clearly
delineating strengths, uncertainties, and assumptions, along with
the impacts of these factors on the overall assessment. The data,
assumptions, models, and inferences used in the risk assessment to
construct quantitative characterizations of the probabilities of occurrence
of health, safety, or ecological effects should not reflect unstated
or unsupported preferences for protecting public health and the environment,
or unstated safety factors to account for uncertainty and unmeasured
variability. Such procedures may introduce levels of conservatism
that cumulate across assumptions and make it difficult for decisionmakers
to evaluate the magnitude of the risks involved.
Risk assessment. The assessment of outcomes associated with regulatory
action to address risks to health, safety, and the environment raises
a number of scientific difficulties. Key issues involve the quality
and reliability of the data, models, assumptions, scientific inferences,
and other information used in risk analyses. Analysts rarely, if
ever, have complete information. It may be difficult to identify
the full range of impacts. Little definitive may be known about
the structure of key relationships and therefore about appropriate
model specification. Data relating to effects that can be identified
may be sketchy, incomplete, or subject to measurement error or statistical
bias. Exposures and sensitivities to risks may vary considerably
across the affected population. These difficulties can lead, for
example, to a range of quantitative estimates of risk in health
and ecological risk assessments that can span several orders of
magnitude. Uncertainties in cost estimates also can be significant,
in particular because of lack of experience with the adjustments
that markets can make to reduce regulatory burdens, the difficulty
of identifying and quantifying opportunity cost, and the potential
for enhanced or retarded technical innovation. All of these concerns
should be reflected in the uncertainties about outcomes that should
be incorporated in the analysis.
The treatment of uncertainty in developing risk, benefit, and
cost information also must be guided by the principles of full
disclosure and transparency, as with other elements of an EA.
Data, models, and their implications for risk assessment should
be identified in the risk characterization. Inferences and assumptions
should be identified and evaluated explicitly, together with adequate
justifications of choices made, and assessments of the effects
of these choices on the analysis.
Informed judgment is necessary to evaluate conflicting scientific
theories. In some cases it may be possible to weigh conflicting
evidence in developing the overall risk assessment. In other cases,
the level of scientific uncertainty may be so large that a risk
assessment can only present discrete alternative scenarios without
a quantitative assessment of their relative likelihood. For example,
in assessing the potential outcomes of an environmental effect,
there may be a limited number of scientific studies with strongly
divergent results. In such cases, the assessment should present
results representing a range of plausible scenarios, together
with any information that can help in providing a qualitative
judgment of which scenarios are more scientifically plausible.
In the absence of adequate valid data, properly identified assumptions
are necessary for conducting an assessment. The existence of plausible
alternative models and their implications should be carried through
as part of each risk characterization product. Alternative models
and assumptions should be used in the risk assessment as needed
to provide decisionmakers with information on the robustness of
risk estimates and estimates of regulatory impacts. As with other
elements of an EA, there should be balance between thoroughness
of analysis in the treatment of risk and uncertainty and practical
limits on the capacity to carry out analysis. The range of models,
assumptions, or scenarios presented in the risk assessment need
not be exhaustive, nor is it necessary that each alternative be
evaluated at every step of the assessment. The assessment should
provide sufficient information for decisionmakers to understand
the degree of scientific uncertainty and the robustness of estimated
risks, benefits, and costs. The choice of models or scenarios
used in the risk assessment should be explained.
Where feasible, data and assumptions should be presented in a
manner that permits quantitative evaluation of their incremental
effects. The cumulative effects of assumptions and inferences
should also be evaluated. A full characterization of risks should
include findings for the entire affected population and relevant
subpopulations. Assumptions should be consistent with reasonably
obtainable scientific information. Thus, for example, low-dose
toxicity extrapolations should be consistent with physiological
knowledge; assumptions about environmental fate and transport
of contaminants should be consistent with principles of environmental
The material provided should permit the reader to replicate the
analysis and quantify the effects of key assumptions. Such analyses
are becoming increasingly easy to perform because of advances
in computing power and new methodological developments. Thus,
the level and scope of disclosure and transparency should increase
In order for the EA to evaluate outcomes involving risks, risk
assessments must provide some estimates of the probability distribution
of risks with and without the regulation. Whenever it is possible
to quantitatively characterize the probability distributions,
some estimates of central tendency (e.g., mean and median) must
be provided in addition to ranges, variances, specified low-end
and high-end percentile estimates, and other characteristics of
Overall risk estimates cannot be more precise than their most
uncertain component. Thus, risk estimates should be reported in
a way that reflects the degree of uncertainty present in order
to prevent creating a false sense of precision. The accuracy with
which quantitative estimates are reported must be supported by
the quality of the data and models used. In all cases, the level
of precision should be stated explicitly.
Overall uncertainty is typically a consequence of uncertainties
about many different factors. Appropriate statistical techniques
should be used to combine uncertainties about separate factors
into an overall probability distribution for a risk. When such
techniques cannot be used, other methods may be useful for providing
more complete information:
Monte Carlo analysis and other simulation methods can be used
to estimate probability distributions of the net benefits
of alternative policy choices. It requires explicit quantitative
characterization of variability to derive an overall probability
distribution of net benefits. Parameter or model probability
distributions may be derived empirically (for example, directly
from population data or indirectly from regression or other
statistical models) or by assumption. This approach has the
advantage of weighing explicitly the likelihood of alternative
outcomes, permitting evaluation of their relative importance.
However, care must be taken to consider the entire output
of the analysis rather than placing undue reliance on any
one statistic. Because of the sensitivity of such simulations
to assumptions about correlations between parameters, the
likelihood that a particular specification is correct, omitted
factors, and assumptions about the distribution of parameters,
etc., special care should be taken to address these potential
pitfalls. The quality of the overall analysis is only as good
as the quality of its components; faulty assumptions or model
specifications will yield faulty results.
Sensitivity analysis is carried out by conducting analyses
over the full range of plausible values of key parameters
and plausible model specifications. Sensitivity analysis is
particularly attractive when there are several easily identifiable
critical assumptions in the analysis, when information is
inadequate to carry out a more formal probabilistic simulation,
or when the nature and scope of the regulation do not warrant
more extensive analysis. One important form of sensitivity
analysis involves estimating "switch points," that is, critical
parameter values at which estimated net benefits change sign.
Sensitivity analysis is useful for evaluating the robustness
of conclusions about net benefits with respect to changes
in model parameters. Sensitivity analysis should convey as
much information as possible about the likely plausibility
or frequency of occurrence of different scenarios (sets of
parameter values) considered.
Delphi methods involve derivation of estimates by groups of
experts and can be used to identify attributes of subjective
probability distributions. This method can be especially useful
when there is diffuse or divergent prior knowledge. Care must
be taken, however, to preserve any scientific controversy
arising in a delphi analysis.
Meta-analysis involves combining data or results from a number
of different studies. For example, one could re-estimate key
model parameters using combined data from a number of different
sources, thereby improving confidence in the parameter estimates.
Alternatively, one could use parameter estimates (elasticities
of supply and demand, implicit values of mortality risk reduction)
from a number of different studies as data points, and analyze
variations in those results as functions of potential causal
factors. Care must be taken to ensure that the data used are
comparable, that appropriate statistical methods are used,
and that spurious correlation problems are considered. One
significant pitfall in the use of meta-analysis arises from
combining results from several studies that do not measure
comparable independent or dependent variables.
New methods may become available in the future as well. This document
is not intended to discourage or inhibit their use, but rather
to encourage and stimulate their development.
Uncertainty may arise from a variety of fundamentally different
sources, including lack of data, variability in populations or
natural conditions, limitations in fundamental scientific knowledge
(both social and natural) resulting in lack of knowledge about
key relationships, or fundamental unpredictability of various
phenomena. The nature of these different sources may suggest different
approaches. For example, when uncertainty is due to lack of information,
one policy alternative may be to defer action pending further
study. One factor that may help determine whether further study
is justifiable as a policy alternative is an evaluation of the
potential benefits of the information relative to the resources
needed to acquire it and the potential costs of delaying action.
When uncertainty is due largely to observable variability in populations
or natural conditions, one policy alternative may be to refine
targeting, that is, to differentiate policies across key subgroups.
Analysis of such policies should consider the incremental benefits
of improved efficiency from targeting, any incremental costs of
monitoring and enforcement, and changes in the distribution of
benefits and costs.
risk levels and changes. To value changes in risk arising from variability
in expected outcomes as a consequence of regulation, agencies should
consider the expected net benefits of the risk change, taking into
account the probability distribution of potential outcomes with
and without the regulation. The more familiar examples deal with
valuing risks associated with incurring possible future costs. When
costs are subject to risk, they are generally appraised by risk-averse
individuals at more than the expected value. For example, riskier
financial instruments must generally earn a higher average rate
of return in order to attract investors. Similarly, the owner of
a facility may be willing to pay more to reduce the probability
of fire than the reduction in expected loss, because of aversion
to the risk of the loss. This also explains why property owners
are willing to buy fire insurance at a price that exceeds expected
losses. To accurately value the net benefits of a regulation, regulation-induced
changes in expenditures on self-protection, mitigation, or other
risk-reduction measures should be included.
Under the standard assumption in economic theory that individuals
make choices among outcomes subject to risks to maximize expected
utility, risk aversion is incorporated into net benefits estimates
by expressing benefits and costs in terms of their certainty equivalents.
Certainty equivalents are defined as net benefits occurring with
certainty that would have the same value to individuals as the
expected value of an alternative whose net benefits are subject
to risk. For risk-averse individuals, the certainty equivalent
of such a net benefit stream would be smaller than the expected
value of those net benefits, because risk intrinsically has a
negative value. The difference between the expected value of net
benefits subject to risk and the certainty equivalent is called
the risk premium. Similarly, regulations that reduce the overall
variability of net benefits will have a certainty equivalent value
that is larger than the expected value of the net benefits by
an amount that reflects the value of the variability of outcomes.
Typically total expected net benefits and risk premia are calculated
on the basis of a representative set of individual preferences.
Agencies should also present available information on the incidence
of benefits, costs, and risks where necessary for judging distributional
consequences. Where information is available on differences in
valuation across income levels or other identifiable criteria,
agencies can use this information and information on the incidence
of regulatory effects in calculating total net benefits estimates.
The importance of including estimates of individuals' willingness
to pay for risk reduction varies. Willingness to pay for reduced
risks is likely to be more significant if risks are difficult
to diversify because of incomplete risk and insurance markets,
or if the net benefits of the regulation are correlated with overall
market returns to investment. When the effects of regulation fall
primarily on private parties, it is sufficient to incorporate
measures of individual risk aversion. For regulatory benefits
or costs that accrue to the Federal government (for example, income
from oil production), the Federal government should be treated
as risk neutral because of its high degree of diversification.
As noted in the previous section, the discount rate generally
should not be adjusted as a device to account for the uncertainty
of future benefits or costs. Any allowance for uncertainty should
be made by adjusting the monetary values of changes in benefits
or costs (for the year in which they occur) so that they are expressed
in terms of their certainty equivalents. The adjustment for uncertainty
may well vary over time because the degree of uncertainty may
change. For example, price forecasts are typically characterized
by increasing uncertainty (forecast error) over time, because
of an increasing likelihood of unforeseen (and unforeseeable)
changes in market conditions as time passes. In such cases, the
certainty equivalents of net benefits will tend to change systematically
over time; these changes should be taken into account in analyzing
regulations that have substantial effects over a long time period.
Uncertainty that increases systematically over time will result
in certainty equivalents that fall systematically over time; however,
these decreases in certainty equivalents will mimic the effects
of an increase in the discount rate only under special circumstances.
Where benefit or cost estimates are heavily dependent on certain assumptions,
it is essential to make those assumptions explicit and, where alternative
assumptions are plausible, to carry out sensitivity analyses based on
the alternative assumptions. If the value of net benefits changes sign
with alternative plausible assumptions, further analysis may be necessary
to develop more evidence on which of the alternative assumptions is
more appropriate. Because the adoption of a particular estimation methodology
sometimes implies major hidden assumptions, it is important to analyze
estimation methodologies carefully to make hidden assumptions explicit.
challenges arise in evaluating the results of an EA that relies strongly
upon proprietary data or analyses whose disclosure is limited by confidentiality
agreements. In some cases, such data and analysis may be the best,
or even the only, means to address an important aspect of a proposed
regulation. Nevertheless, given the difficulties that this confidentiality
presents to OMB review and meaningful public participation in the
rulemaking, agencies should exercise great care in relying strongly
upon proprietary material in developing an EA. When such material
is used, it is essential that agencies provide as much information
as possible concerning the underlying scientific, technological, behavioral,
and valuation assumptions and conclusions. This can be accomplished,
for example, by providing information about the values of key input
parameters used in a modeling analysis or the implied behavioral response
rates derived from sensitivity analysis.
effectiveness of proposed rules may depend in part upon agency enforcement
strategies, which may vary over time as agency priorities and budgetary
constraints change. Because an agency usually cannot commit to an
enforcement strategy at the time the rule is promulgated, the analysis
of a rule's benefits and costs should generally assume that compliance
with the rule is complete, although there may be circumstances when
other assumptions should be considered as well. The analysis of a
new or revised rule should differentiate between its benefits and
costs, given an assumed level of compliance, and the implications
of changes in compliance with an existing rule.
Trade Effects. In calculating the benefits and costs of a proposed
regulatory action, generally no explicit distinction needs to be made
between domestic and foreign resources. If, for example, compliance
with a proposed regulation requires the purchase of specific equipment,
the opportunity cost of that equipment is ordinarily best represented
by its domestic cost in dollars, regardless of whether the equipment
is produced domestically or imported. The relative value of domestic
and foreign resources is correctly represented by their respective dollar
values, as long as the foreign exchange value of the dollar is determined
by the exchange market. Nonetheless, an awareness of the role of international
trade may be quite useful for assessing the benefits and costs of a
proposed regulatory action. For example, the existence of foreign competition
may make the demand curve facing a domestic industry more elastic than
it would be otherwise. Elasticities of demand and supply frequently
can significantly affect the magnitude of the benefits or costs of a
limiting imports -- whether through direct prohibitions or fees, or
indirectly through an adverse differential effect on foreign producers
or consumers relative to domestic producers and consumers -- raise
special analytic issues. The economic loss to the United States from
limiting imports should be reflected in the net benefit estimate.
However, a benefit-cost analysis will generally not be able to measure
the potential U.S. loss from the threat of future retaliation by foreign
governments. This threat should then be treated as a qualitative cost
(see section 7).
Benefits and Costs. Presentation of monetized benefits and costs
is preferred where acceptable estimates are possible. However, monetization
of some of the effects of regulations is often difficult if not impossible,
and even the quantification of some effects may not be easy. Effects
that cannot be fully monetized or otherwise quantified should be described.
Those effects that can be quantified should be presented along with
qualitative information to characterize effects that are not quantified.
of the presentation of monetized benefits and costs, the EA should
present available physical or other quantitative measures of the effects
of the alternative actions to help decisionmakers understand the full
effects of alternative actions. These include the magnitude, timing,
and likelihood of impacts, plus other relevant dimensions (e.g., irreversibility
and uniqueness). For instance, assume the effects of a water quality
regulation include increases in fish populations and habitat over
the affected stream segments and that it is not possible to monetize
such effects. It would then be appropriate to describe the benefits
in terms of stream miles of habitat improvement and increases in fish
population by species (as well as to describe the timing and likelihood
of such effects, etc.). Care should be taken, however, when estimates
of monetized and physical effects are mixed in the same analysis so
as to avoid double-counting of benefits. Finally, the EA should distinguish
between effects unquantified because they were judged to be relatively
unimportant, and effects that could not be quantified for other reasons.
Effects and Equity. Those who bear the costs of a regulation and
those who enjoy its benefits often are not the same people. The term
"distributional effects" refers to the description of the net effects
of a regulatory alternative across the population and economy, divided
up in various ways (e.g., income groups, race, sex, industrial sector).
Benefits and costs of a regulation may be distributed unevenly over
time, perhaps spanning several generations. Distributional effects may
also arise through "transfer payments" arising from a regulatory action.
For example, the revenue collected through a fee, surcharge, or tax
(in excess of the cost of any service provided) is a transfer payments.
distributive effects are thought to be important, the effects of various
regulatory alternatives should be described quantitatively to the
extent possible, including their magnitude, likelihood, and incidence
of effects on particular groups. Agencies should be alert for situations
in which regulatory alternatives result in significant changes in
treatment or outcomes for different groups. Effects on the distribution
of income that are transmitted through changes in market prices can
be important, albeit sometimes difficult to assess. The EA should
also present information on the streams of benefits and costs over
time in order to provide a basis for judging intertemporal distributional
consequences, particularly where intergenerational effects are concerned.
are no generally accepted principles for determining when one distribution
of net benefits is more equitable than another. Thus, the EA should
be careful to describe distributional effects without judging their
fairness. These descriptions should be broad, focusing on large groups
with small effects per capita as well as on small groups experiencing
large effects per capita. Equity issues not related to the distribution
of policy effects should be noted when important and described quantitatively
to the extent feasible.
The EA should
state the beneficial effects of the proposed regulatory change and its
principal alternatives. In each case, there should be an explanation of
the mechanism by which the proposed action is expected to yield the anticipated
benefits. An attempt should be made to quantify all potential real incremental
benefits to society in monetary terms to the maximum extent possible.
A schedule of monetized benefits should be included that would show the
type of benefit and when it would accrue; the numbers in this table should
be expressed in constant, undiscounted dollars. Any benefits that cannot
be monetized, such as an increase in the rate of introducing more productive
new technology or a decrease in the risk of extinction of endangered species,
should also be presented and explained.
The EA should
identify and explain the data or studies on which benefit estimates are
based with enough detail to permit independent assessment and verification
of the results. Where benefit estimates are derived from a statistical
study, the EA should provide sufficient information so that an independent
observer can determine the representativeness of the sample, the reliability
of extrapolations used to develop aggregate estimates, and the statistical
significance of the results.
of benefits (including benefits of risk reductions) should reflect the
full probability distribution of potential consequences. For example,
extreme safety or health results should be weighted, along with other
possible outcomes, by estimates of their probability of occurrence based
on the available evidence to estimate the expected result of a proposed
regulation. To the extent possible, the probability distributions of benefits
should be presented. Extreme estimates should be presented as complements
to central tendency and other estimates. If fundamental scientific disagreement
or lack of knowledge precludes construction of a scientifically defensible
probability distribution, benefits should be described under plausible
alternative assumptions, along with a characterization of the evidence
underlying each alternative view. This will allow for a reasoned determination
by decisionmakers of the appropriate level of regulatory action.
It is important
to guard against double-counting of benefits. For example, if a regulation
improves the quality of the environment in a community, the value of real
estate in the community might rise, reflecting the greater attractiveness
of living in the improved environment Inferring benefits from changes
in property values is complex. On the one hand, the rise in property values
may reflect the capitalized value of these improvements. On the other
hand, benefit estimates that do not incorporate the consequences of land
use changes will not capture the full effects of regulation. For regulations
with significant effects on land uses, these effects must be separated
from the capitalization of direct regulatory impacts into property values.
Considerations. The concept of "opportunity cost" is the appropriate
construct for valuing both benefits and costs. The principle of "willingness-to-pay"
captures the notion of opportunity cost by providing an aggregate measure
of what individuals are willing to forgo to enjoy a particular benefit.
Market transactions provide the richest data base for estimating benefits
based on willingness-to-pay, as long as the goods and services affected
by a potential regulation are traded in markets. It is more difficult
to estimate benefits where market transactions are difficult to monitor
or markets do not exist. Regulatory analysts in these cases need to
develop appropriate proxies that simulate market exchange. Indeed, the
analytical process of deriving benefit estimates by simulating markets
may suggest alternative regulatory strategies that create such markets.
willingness-to-pay (WTP) or willingness-to-accept (WTA) can provide
an appropriate measure of benefits, depending on the allocation of
property rights. The common preference for WTP over WTA measures is
based on the empirical difficulties in estimating the latter.
of willingness-to-pay based on observable and replicable behavior
deserve the greatest level of confidence. Greater uncertainty attends
benefit estimates that are neither derived from market transactions
nor based on behavior that is observable or replicable. While innovative
benefit estimation methodologies will be necessary or desirable in
some cases, use of such methods intensifies the need for quality control
to ensure that estimates are reliable and conform as closely as possible
to what would be observed if markets existed.
for Valuing Benefits Directly Traded in Markets. Ordinarily, goods
and services are to be valued at their market prices. However, in some
instances, the market value of a good or service may not reflect its
true value to society.
regulatory alternative involves changes in such a good or service,
its monetary value for purposes of benefit-cost analysis should be
derived using an estimate of its true value to society (often called
its "shadow price"). For example, suppose a particular air pollutant
damages crops. One of the benefits of controlling that pollutant will
be the value of the crop saved as a result of the controls. That value
would typically be determined by reference to the price of the crop.
If, however, the price of that crop is held above the unregulated
market equilibrium price by a government price-support program, an
estimate based on the support price would overstate the value of the
benefit of controlling the pollutant. Therefore, the social value
of the benefit should be calculated using a shadow price for crops
subject to price supports. The estimated shadow price is intended
to reflect the value to society of marginal uses of the crop (e.g.,
the world price if the marginal use is for exports). If the marginal
use is to add to very large surplus stockpiles, the shadow price would
be the value of the last units released from storage minus storage
cost. Therefore, where stockpiles are large and growing, the shadow
price is likely to be low and could well be negative.
cases, market prices could understate social values, for example where
production of a particular good also provides opportunities for improving
for Valuing Benefits That Are Indirectly Traded in Markets. In some
important instances, a benefit corresponds to a good or service that
is indirectly traded in the marketplace. Examples include reductions
in health-and-safety risks, the use-values of environmental amenities
and scenic vistas. To estimate the monetary value of such an indirectly
traded good, the willingness-to-pay valuation methodology is considered
the conceptually superior approach. As noted in Sections 4 and 5 immediately
following, alternative methods may be used where there are practical
obstacles to the accurate application of direct willingness-to-pay methodologies.
of methods have been developed for estimating indirectly traded benefits.
Generally, these methods apply statistical techniques to distill from
observable market transactions the portion of willingness-to-pay that
can be attributed to the benefit in question. Examples include estimates
of the value of environmental amenities derived from travel-cost studies,
hedonic price models that measure differences or changes in the value
of land, and statistical studies of occupational-risk premiums in
wage rates. For all these methods, care is needed in designing protocols
for reliably estimating benefits or in adapting the results of previous
studies to new applications. The use of occupational-risk premiums
can be a source of bias because the risks, when recognized, may be
voluntarily rather than involuntarily assumed, and the sample of individuals
upon which premium estimates are based may be skewed toward more risk-tolerant
methods have become increasingly common for estimating indirectly
traded benefits, but the reliance of these methods on hypothetical
scenarios and the complexities of the goods being valued by this technique
raise issues about its accuracy in estimating willingness to pay compared
to methods based on (indirect) revealed preferences. Accordingly,
value estimates derived from contingent-valuation studies require
greater analytical care than studies based on observable behavior.
For example, the contingent valuation instrument must portray a realistic
choice situation for respondents -- where the hypothetical choice
situation corresponds closely with the policy context to which the
estimates will be applied. The practice of contingent valuation is
rapidly evolving, and agencies relying upon this tool for valuation
should judge the reliability of their benefit estimates using this
technique in light of advances in the state of the art.
and Methods for Valuing Goods That Are Not Traded Directly or Indirectly
in Markets. Some types of goods, such as preserving environmental
or cultural amenities apart from their use and direct enjoyment by people,
are not traded directly or indirectly in markets. The practical obstacles
to accurate measurement are similar to (but generally more severe than)
those arising with respect to indirect benefits, principally because
there are few or no related market transactions to provide data for
many of these goods, particularly goods providing "nonuse" values,
contingent-valuation methods may provide the only analytical approaches
currently available for estimating values. The absence of observable
and replicable behavior with respect to the good in question, combined
with the complex and often unfamiliar nature of the goods being valued,
argues for great care in the design and execution of surveys, rigorous
analysis of the results, and a full characterization of the uncertainties
in the estimates to meet best practices in the use of this method.
for Valuing Health and Safety Benefits. Regulations that address
health and safety concerns often yield a variety of benefits traded
directly in markets, benefits indirectly traded in markets, and benefits
not traded in markets. A major component of many such regulations
is a reduction is the risk of illness, injury or premature death.
There are differences of opinion about the various approaches for
monetizing such risk reductions. In assessing health and safety benefits,
the analysis should present estimates of both the risks of nonfatal
illness or injury and fatality risks, and may include any particular
strengths or weakness of such analyses the agencies think appropriate,
in order to accurately assess the benefits of government action.
Nonfatal illness and injury. Although the willingness-to-pay approach
is conceptually superior, measurement difficulties may cause the
agency to prefer valuations of reductions in risks of nonfatal illness
or injury based on the expected direct costs avoided by such risk
reductions. For example, an injury-value estimate from a willingness-to-pay
study may be an average over a specific combination of injuries
of varying severity. If the average injury severity in such a study
differs greatly from the injury severity addressed by the regulatory
action, then the study's estimated injury value may not be appropriate
for evaluating that action. More generally, willingness-to-pay estimates
may be unavailable or too tentative to provide a solid base for
the evaluation. The agency should use whatever approach it can justify
as most appropriate for the decision at hand, keeping in mind that
direct cost measures can be expected to understate the true cost.
As discussed above (Section III.A.3), costs and benefits should
be appropriately discounted to reflect the latency period between
exposure and illness.
The primary components of the direct-cost approach are medical
and other costs of offsetting illness or injury; costs for averting
illness or injury (e.g., expenses for goods such as bottled water
or job safety equipment that would not be incurred in the absence
of the health or safety risk); and the value of lost production.
Possibly important costs that might be omitted by the use of the
direct-cost approach are the costs of pain, suffering and time
lost (due to illness, injury, or averting behavior) from leisure
and other activities that are not directly valued in the market.
The present value of the expected stream of costs should be included.
For long-term chronic illness or incapacitation the direct-cost
approach may be particularly problematic compared to a willingness-to-pay
estimate analogous to the valuation of mortality risks (discussed
Valuing lost production and other time-related costs gives rise
to a number of methodological concerns. For occupational illness
or injury, lost production can be measured by losses in workers'
value of marginal product. In valuing the effects of broader environmental
hazards, however, attention must be given to the composition of
the exposed population. For example, some portion of the working-age
population may be unemployed, while others will be retired. Still
others may have chosen to be homemakers or home caregivers. Valuation
of nonfatal illness or injury to these parts of the population
presents a greater challenge than valuing the loss of employee
services using wage rates. Finally, the valuation of health impacts
on children or retirees through the direct-cost approach is especially
problematic since their zero opportunity cost in the labor market
is not a good proxy for the social cost of illness. The agency
should use whatever approach it can justify but should provide
a clear explanation of the assumptions and reasoning used in the
Fatality risks. Values of fatality risk reduction often figure prominently
in assessments of government action. Estimates of these values that
are as accurate as possible, given the circumstances being assessed
and the state of knowledge, will reduce the prospects for inadequate
or excessive action.
Reductions in fatality risks as a result of government action
are best monetized according to the willingness-to-pay approach.
The value of changes in fatality risk is sometimes expressed in
terms of the "value of statistical life" (VSL) or the "value of
a life". These terms are confusing at best and should be carefully
described when used. It should be made clear that these terms
refer to the willingness to pay for reductions in risks of premature
death (scaled by the reduction in risk being valued). That is,
such estimates refer only to the value of relatively small changes
in the risk of death. They have no application to an identifiable
There is also confusion about the term "statistical life." This
terms refers to the sum of risk reductions expected in a population.
For example, if the annual risk of death is reduced by one in
a million for each of two million people, that represents two
"statistical lives" saved per year (two million x one millionth
= two). If the annual risk of death is reduced by one in 10 million
for each of 20 million people, that also represents two statistical
Another way of expressing reductions in fatality risks is in terms
of the "value of statistical life-years extended" (VSLY). For
example, if a regulation protected individuals whose average remaining
life expectancy was 40 years, then a risk reduction of one fatality
would be expressed as 40 life-years extended. This approach allows
distinctions in risk-reduction measures based on their effects
on longevity. However, this does not automatically mean that regulations
with greater numbers of life-years extended will be favored over
regulations with fewer numbers of life-years extended. VSL and
VSLY ultimately depend on the willingness to pay for various forms
of mortality risk reduction, not just longevity considerations.
As described below, there are several ways that the benefits of
mortality risk reduction can be estimated. In considering these
alternatives, however, it is important to keep in mind the larger
objective of consistency -- subject to statutory limitations --
in the estimates of benefits applied across regulations and agencies
for comparable risks. Failure to maintain such consistency prevents
achievement of the most risk reduction from a given level of resources
spent on risk reduction. The valuation of mortality risk reduction
is an evolving area in terms of results and methodology. Agencies
generally should utilize valuation estimates, either explicitly
or implicitly calculated, that are consistent with the current
state of knowledge at the time that the analysis is being performed,
and should show that their approach to valuation reflects the
current state of knowledge. Significant deviations from the prevailing
state of knowledge should be explained.
methodological frameworks for estimating benefits from reduced fatality
risks. Several alternative ways of incorporating the value of reducing
fatality risks into the framework of benefit-cost analysis may be
appropriate. These may involve either explicit or implicit valuation
of fatality risks, and generally involve the use of estimates of
the VSL from studies on wage compensation for occupational hazards
(which generally are in the range of 10-4 annually), on consumer
product purchase and use decisions, or from a limited literature
using contingent-valuation approaches. Because these estimates may
not be entirely appropriate for the risk being evaluated in some
cases (e.g., the use of occupational risk premia for environmental
hazards), agencies should provide an explanation for their selection
of estimates and for any adjustments of the estimates to reflect
the nature of the risk being evaluated.
One acceptable explicit valuation approach would be for the agency
to select a single estimate of the value of reductions in fatality
risk at ordinarily encountered risk levels, or a distribution
of such values, and use these values consistently for evaluating
all its programs that affect ordinary fatality risks. Where the
analysis uses a range of alternative values for reductions in
fatality risk, it may be useful to calculate break-even values,
as in other sensitivity analyses. This requires calculating the
borderline value of reductions in fatality risk at which the net
benefit decision criterion would switch over from favoring one
alternative to favoring another (i.e., the value of fatality risk
at which the net benefits of the two alternatives are equal).
This method will frequently be infeasible because of its computational
demands but, where feasible, it may be a useful addition to the
An implicit valuation approach that could be used entails calculations
of the net incremental cost per unit of reduction in fatality
risk (cost per "statistical life saved") of alternative measures,
with net incremental costs defined as costs minus monetized benefits.
Alternatives can be arrayed in order of increasing reductions
in expected fatalities. Generally this will also correspond to
increasing incremental cost. (It is possible that there will be
some initial economies of scale, with declining incremental costs.
If incremental costs are declining over a broad range of alternative
measures, it is likely that there are flaws in the definition
of the measures or the estimation of their effects.) The incremental
cost per life saved then can be calculated for each adjacent pair
of alternatives. With this construction, the choice to undertake
a certain set of measures while eschewing others implies a lower
and upper bound for the value per life saved; it would be at least
as large as the incremental cost of the most expensive measure
undertaken, but not as large as the cheapest measure not undertaken.
In contrast to explicit valuation approaches, this avoids the
necessity of specifying in advance a value for reductions in fatality
risks. However, the range of values should be consistent with
estimated values of reductions in fatality risks calculated according
to the willingness-to-pay methodology, and the method should be
consistently applied across regulatory decisions (within statutory
limitations), in order to assure that regulation achieves the
greatest risk reduction possible from the level of resources committed
to risk reduction.
While there are theoretical advantages to using a value of statistical
life-year-extended approach, current research does not provide
a definitive way of developing estimates of VSLY that are sensitive
to such factors as current age, latency of effect, life years
remaining, and social valuation of different risk reductions.
In lieu of such information, there are several options for deriving
the value of a life-year saved from an estimate of the value of
life, but each of these methods has drawbacks. One approach is
to use results from the wage compensation literature (which focus
on the effect of age on WTP to avoid risk of occupational fatality).
However, these results may not be appropriate for other types
of risks. Another approach is to annualize the VSL using an appropriate
rate of discount and the average life years remaining. This approach
does not provide an independent estimate of VSLY; it simply rescales
the VSL estimate. Agencies should consider providing estimates
of both VSL and VSLY, while recognizing the developing state of
knowledge in this area.
Whether the VSLs (or VSLYs) are chosen explicitly or are an implicit
outcome of a cost-effectiveness approach, the choice of estimates
ideally should be based on a comparison of the context of the
regulation affecting risks and the context of the study or studies
being relied on for value estimates. The literature identifies
certain attributes of risk that affect value. These attributes
include the baseline risk, the extent to which the risk is voluntarily
or involuntarily assumed, and features (such as age) of the population
exposed to risk. For regulations affecting some segments of the
population (e.g., infants) more than those groups which have served
as the basis for most of the information used to estimates VSLs
(e.g., working-age adults), the use of VSLs from the literature
may not be appropriate. At a minimum, differences in regulatory
and study contexts should be acknowledged and a rationale for
the choice of the value estimate should be provided.
Based on the literature, both the scale of baseline risks and
their degree of voluntariness appear to affect VSLs. However,
the risk from an involuntary hazard typically is too small to
represent a significant portion of baseline risk. (For example,
average annual mortality risks for men aged 55-64 are about two
per hundred, while occupational fatality risk reductions typically
achieved by regulations are between two per ten thousand and two
per million annually.) In such cases, it may be legitimate to
assume that the valuation of risks can be treated as independent
of baseline risk.
To value reductions in more voluntarily incurred risks (e.g.,
those related to motorcycling without a helmet) that are "high,"
agencies should consider using lower values than those applied
to reductions in involuntary risk. When a higher-risk option is
chosen voluntarily, those who assume the risk may be more risk-tolerant,
i.e., they may place a relatively lower value on avoiding risks.
Empirical studies of risk premiums in higher-risk occupations
suggest that reductions in risks for voluntarily assumed high
risk jobs (e.g., above 10-4 annually) are valued less than equal
risk reductions for lower-risk jobs. However, when occupational
choices are limited, the occupational risks incurred may be more
involuntary in nature.
Considerations. The preferred measure of cost is the "opportunity
cost" of the resources used or the benefits forgone as a result of the
regulatory action. Opportunity costs include, but are not limited to,
private-sector compliance costs and government administrative costs.
Opportunity costs also include losses in consumers' or producers' surpluses,
discomfort or inconvenience, and loss of time. These effects should
be incorporated in the analysis and given a monetary value wherever
possible. (Producers' surplus is the difference between the amount a
producer is paid for a unit of a good and the minimum amount the producer
would accept to supply that unit. It is measured by the area between
the price and the supply curve for that unit. Consumers' surplus is
the difference between what a consumer pays for a unit of a good and
the maximum amount the consumer would be willing to pay for that unit.
It is measured by the distance between the price and the demand curve
for that unit.)
opportunity cost of an alternative also incorporates the value of
the benefits forgone as a consequence of that alternative. For example,
the opportunity cost of banning a product (e.g., a drug, food additive,
or hazardous chemical) is the forgone net benefit of that product,
taking into account the mitigating effects of potential substitutes.
As another example, even if a resource required by regulation does
not have to be paid for because it is already owned by the regulated
firm, the use of that resource to meet the regulatory requirement
has an opportunity cost equal to the net benefit it would have provided
in the absence of the requirement. Any such forgone benefits should
be monetized wherever possible and either added to the costs or subtracted
from the benefits of that alternative. Any costs that are averted
as a result of an alternative should be monetized wherever possible
and either added to the benefits or subtracted from the costs of that
costs calculated should be incremental, that is, they should represent
changes in costs that would occur if the regulatory option is chosen
compared to costs in the base case (ordinarily no regulation or the
existing regulation) or under a less stringent alternative. Future
costs that would be incurred even if the regulation is not promulgated,
as well as costs that have already been incurred (sunk costs), are
not part of incremental costs. If marginal cost is not constant for
any component of costs, incremental costs should be calculated as
the area under the marginal cost curve over the relevant range. A
schedule of monetized costs should be included that would show the
type of cost and when it would occur; the numbers in this table should
be expressed in constant, undiscounted dollars.
EA should identify and explain the data or studies on which cost estimates
are based with enough detail to permit independent assessment and
verification of the results. Where cost estimates are derived from
a statistical study, the EA should provide sufficient information
so that an independent observer can determine the representativeness
of the sample, the reliability of extrapolations used to develop aggregate
estimates, and the statistical significance of the results.
benefit estimates, the calculation of costs should reflect the full
probability distribution of potential consequences. Extreme values
should be weighted, along with other possible outcomes, by estimates
of their probability of occurrence based on the available evidence
to estimate the expected result of a proposed regulation. If fundamental
scientific disagreement or lack of knowledge precludes construction
of a scientifically defensible probability distribution, costs should
be described under plausible alternative assumptions, along with a
characterization of the evidence underlying each alternative view.
This will allow for a reasoned determination by decisionmakers of
the appropriate level of regulatory action. That level of action should
derive from the decisionmaking process, not from adjusting cost estimates
upward or downward at the information-gathering or analytical stages
of the process.
of costs should be based on credible changes in technology over time.
For example, a slowing in the rate of innovation or of adoption of
new technology because of delays in the regulatory approval process
or the setting of more stringent standards for new facilities than
existing ones may entail significant costs. On the other hand, a shift
to regulatory performance standards and incentive-based policies may
lead to cost-saving innovations that should be taken into account.
In some cases agencies are limited under statute to considering only
technologies that have been demonstrated to be feasible. In these
situations, it may also be useful to estimate costs and cost savings
assuming a wider range of technical possibilities.
the calculation of benefits, costs should not be double counted. Two
accounting cost concepts that should not be counted as costs in benefit-cost
analysis are interest and depreciation. The time value of money is
already accounted for by the discounting of benefits and costs. Generally,
depreciation is already taken into account by the time distribution
of benefits and costs. One legitimate use for depreciation calculations
in benefit-cost analysis is to estimate the salvage value of a capital
Costs Versus Transfer Payments. An important, but sometimes difficult,
problem in cost estimation is to distinguish between real costs and
transfer payments. Transfer payments are not social costs but rather
are payments that reflect a redistribution of wealth. While transfers
should not be included in the EA's estimates of the benefits and costs
of a regulation, they may be important for describing the distributional
effects of a regulation. Scarcity rents and monopoly profits, insurance
payments, government subsidies and taxes, and distribution expenses
are four potential problem areas that may affect both social benefits
and costs as well as involve significant transfer payments.
Scarcity rents and monopoly profits. If, for example, sales of
a competitively produced product were restricted by a government
regulation so as to raise prices to consumers, the resulting profit
increases for sellers are not a net social benefit of the rule,
nor is their payment by consumers generally a net social cost,
though there may be important distributional consequences. The
social benefit-cost effects of the regulation would be represented
by changes in producers' and consumers' surpluses, including the
net surplus reduction from reduced availability of the product.
The same conclusion applies if the government restriction provides
an opportunity for the exercise of market power by sellers, in
which case the net cost of the regulation would include the cost
of reduced product provision due both to the government mandate
and the induced change in market structure.
Insurance payments. Potential pitfalls in benefit-cost analysis
may also arise in the case of insurance payments, which are transfers.
Suppose, for example, a worker safety regulation, by decreasing
employee injuries, led to reductions in firms' insurance premium
payments. It would be incorrect to count the amount of the reduction
in insurance premiums as a benefit of the rule. The proper measure
of benefits for the EA is the value of the reduction in worker
injuries, monetized as described previously, plus any reduction
in real costs of administering insurance (such as the time insurance
company employees needed to process claims) due to the reduction
in worker insurance claims. Reductions in insurance premiums that
are matched by reductions in insurance claim payments are changes
in transfer payments, not benefits.
Indirect taxes and subsidies. A third instance where special treatment
may be needed to deal with transfer payments is the case of indirect
taxes (tariffs or excise taxes) or subsidies on specific goods
or services. Suppose a regulation requires firms to purchase a
$10,000 piece of imported equipment, on which there is a $1,000
customs duty. For purposes of benefit-cost analysis, the cost
of the regulation for each firm ordinarily would be $10,000, not
$11,000, since the $1,000 customs duty is a transfer payment from
the firm to the Treasury, not a real resource cost. This approach,
which implicitly assumes that the equipment is supplied at constant
costs, should be used except in special circumstances. Where the
taxed equipment is not supplied at constant cost, the technically
correct treatment is to calculate how many of the units purchased
as a result of the regulation are supplied from increased production
and how many from decreased purchases by other buyers. The former
units would be valued at the price without the tax and the latter
units would be valued at the price including tax. This calculation
is usually difficult and imprecise because it requires estimates
of supply and demand elasticities, which are often difficult to
obtain and inexact. Therefore, this treatment should only be used
where the benefit-cost conclusions are likely to be sensitive
to the treatment of the indirect tax. While costs ordinarily should
be adjusted to remove indirect taxes on specific goods or services
as described here, similar treatment is not warranted for other
taxes, such as general sales taxes applying equally to most goods
and services or income taxes.
Distribution expenses. The treatment of distribution expenses
is also a source of potential error. For example, suppose a particular
regulation raises the cost of a product by $100 and that wholesale
and retail distribution expenses are on average 50 percent of
the factory-level cost. It would ordinarily be incorrect to add
a $50 distribution markup to the $100 cost increase to derive
a $150 incremental cost per product for benefit-cost analysis.
Most real resource costs of distribution do not increase with
the price of the product being distributed. In that case, either
distribution expenses would be unchanged or, if they increased,
the increase would represent distributor monopoly profits. Since
the latter are transfer payments, not real resource costs, in
neither case should additional distribution expenses be included
in the benefit-cost analysis. However, increased distribution
expenses should be counted as costs to the extent that they correspond
to increased real resource costs of the distribution sector as
a result of the change in the price or characteristics of the
product, or if regulation directly affects distribution costs.
D. Bentkover, Vincent T. Covello, and Jeryl Mumpower, Eds., Benefits Assessment:
The State of the Art.
and John G. Riley, The Analytics of Uncertainty and Information. An advanced
treatment of many issues related to risk and uncertainty.
The Measurement of Environmental and Resource Values: Theory and Methods.
A comprehensive high-level treatment of environmental valuation issues.
Lind, Ed., Discounting for Time and Risk in Energy Policy. An advanced
treatment of issues related to public and private sector discounting.
E. J. Mishan,
Economics for Social Decisions: Elements of Cost-Benefit Analysis. Assumes
some knowledge of economics. Chapters 5-8 should be helpful on the important
subjects of producers' and consumers' surpluses (not discussed extensively
in this guidance document).
Mitchell and Richard C. Carson, Using Surveys to Value Public Goods: The
Contingent Valuation Method. Provides a valuable discussion on the potential
strengths and pitfalls associated with the use of contingent-valuation
Smith, Ed., Advances in Applied Micro-economics: Risk, Uncertainty, and
the Valuation of Benefits and Costs.
and Richard Zeckhauser, A Primer for Policy Analysis. Chapters 9 and 10
provide a good introduction to basic concepts.
Donald Kenkel, and Robert Fabian, Eds., Valuing Health for Policy: An
Economic Approach. An excellent summary of methods to value reduction
in morbidity and extensions to life expectancy.
W. Kip Viscusi,
Risk By Choice. Chapter 6 is a good starting point for the topic of valuing
health and safety benefits. Other more technical sources are given in