By D. W. Pearce (auth.)
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Extra resources for Cost-Benefit Analysis
The 'certainty equivalent' approach requires that the analyst find the decisionmaker's rate of trade-off between mean and variance values. In effect, it is necessary to find an indifference map which-measures mean values on one axis and variance values on the other. Once this is known, any combination of mean and variance can be 'reduced' to a certainty equivalent by moving down the indifference curve to the point where variance is zero. " The obvious difficulty with the approach is to find the decisionmaker's indifference map.
A further problem exists in that profit-maximising concerns will not take account of the third-party effects of their actions. That is, they will ignore external costs and benefits. To the extent that they 52 do this, the prices charged for their goods will not reflect true social costs. The argument of the preceding paragraph can therefore be restated. Shadow prices should reflect marginal social costs rather than marginal private costs. In practice, prices are not likely to reflect either marginal private cost or marginal social cost, owing to the existence of imperfectly competitive markets and external effects.
But Eckstein  has pointed out that a set ofweighted individual utility functions reflecting risk may not combine to be the same as a 'group' utility function, since 'the group as a whole may suffer less than the individual. The variance of the total outcome may be relatively smaller than for each individual because of pooling' (p. 471). To this extent, individuals' attitudes to risk cease to be the sole determinant of the planner's attitude to risk. The argument for rejecting individual preferences concerning risk is that, even if there is no aggregation problem, these preferences are not observable in a world of imperfect capital markets.
Cost-Benefit Analysis by D. W. Pearce (auth.)