Effective Public Policy Needs More Than Benefit-Cost Analysis
Public policy impacts our lives in a variety of ways. In the United States, government creates and enforces rules concerning employment, food and drug availability, and the use of land, among many other things. In other countries government does even more, such as directly provide healthcare. Researchers can help improve public policies by studying their effects and explaining the challenges that are inherent to the policy-making process.
The process by which governments adopt policies is complex. Various stakeholders, each with their own goals and information, want government to implement their preferred policy. Government officials are thus presented with a variety of policy options - some of which are at odds with one another - while also harboring their own opinions about the best policy.
To compare the proposals, government agencies and research offices, such as the Congressional Budget Office and Office of Information and Regulatory Affairs in the United States, often conduct benefit-cost analyses of the various policies to help inform legislators and administrative personnel. Such analyses can be useful, but even the most rigorous ones have limitations.
"The limitations of benefit-cost analyses arise due to a lack of information."
The first limitation is that they only include benefits and costs that are expected at the time of the analysis. This means any unintended benefits or costs will not factor into the decision. Unintended benefits and costs are inevitable since it is impossible to foresee every person’s or business’s response to a given policy. This is especially true in today’s increasingly interconnected world: technology has made it easier than ever for both firms and people to re-locate to another state or even country in response to policy.
The second big problem with benefit-cost analyses is that they are static. Unintended benefits and costs would be less of a problem if governments regularly re-conducted their benefit-cost analyses and updated policy accordingly, but this rarely occurs. So even when additional benefits or costs emerge or previously known benefits or costs become more or less pronounced, policy typically remains the same. One implication of this is that the effectiveness of any public policy diminishes over time.
One example is occupational licensing regulations. Many supporters of occupational licensing for barbers, hair braiders, and similar occupations argue that such licensing is needed to ensure customer safety. Yet even if that was once true, technology has made it easier to identify unsafe businesses via web applications such as Yelp, Angie’s List, and others. Some states have responded to this new technology by reducing licensing requirements, but many others maintain their old licensing restrictions despite the decline in information costs.
The limitations of benefit-cost analyses arise due to a lack of information. Nobel Laureate in economics F. A. Hayek called the problem of a lack of information that arises with any decision “the knowledge problem”: it is impossible for a person making a decision to know every piece of relevant information. The existence of the knowledge problem means people must make decisions based on incomplete information.
"It’s impossible to know how much people truly value things like national defense, roads, and environmental regulation."
The knowledge problem is, of course, not unique to benefit-cost analyses conducted by government workers. People working in private-sector businesses or making their own personal decisions must also deal with the knowledge problem. However, unlike those working in government, people operating in the marketplace have signals that help mitigate the knowledge problem—prices, profit, and loss. Together, these signals reduce the knowledge problem and help people allocate resources to their highest valued use.
Prices serve two important functions. First, prices let people know how much goods and services are valued relative to one another. The higher the price, the more the good or service is valued. Second, prices act as incentives: when a good or service has a high price compared to other goods and services, people have an incentive to produce more of it.
Profit and loss tell a producer of a good or service if she is creating value. An owner of a profitable coffee shop knows that she is turning coffee grounds, water, electricity, and paper cups into something people value more—a cup of coffee. A coffee shop that is losing money is destroying value since the coffee it is selling is worth less than the resources used to create it. Together, prices, profit, and loss tell people what to produce and how much.
Unfortunately, people in government rarely have access to prices, profit, and loss. Things like national defense, roads, and environmental regulation are not sold on a market, so it’s impossible to know how much people truly value them. Benefit-cost analyses can help, but they are a poor substitute for the clearer and more dynamic signals of prices, profit, and loss that are used in private-sector markets to distinguish useful activities from wasteful ones.
"While the knowledge problem does not have a solution, it can be mitigated."
The knowledge problem pervades government programs. Within the United States, urban planning, education, child welfare, health care, e-commerce regulation, and tax policy all suffer from the knowledge problem. Each of these areas is also subject to extensive government control and oversight and as a result they are largely shielded from market competition, which inhibits the use of prices, profit, and loss as guides.
For example, K-12 education is largely controlled by the states, though the federal government has expanded its role over time. The result is a public education system that is widely considered ineffective and . One potential solution is education savings accounts (ESA) that allow parents to set money aside to use on educational services such as private schools, tutoring, or materials for home schooling. Parents have local knowledge, meaning they tend to know more about their unique circumstances than government officials. ESAs allow parents to use this knowledge to choose the educational services that work best for them and their children.
Public policies more international in scope also suffer from the knowledge problem. One is financial regulations that were implemented after the 9/11 terrorist attacks, such as Know Your Customer rules that require financial institutions to verify the identities of their customers. The intent of these regulations is to penalize financial institutions that allow money laundering or other illicit financial activities that help terrorist organizations or rogue states. Unfortunately, they also incentivize de-risking, which is when financial institutions sever relationships with potentially risky clients to avoid penalties. This can actually harm counterterrorism efforts by forcing the riskiest clients into the underground financial system, which is harder to monitor.
Public policy matters: It often determines the jobs people can do, the schools children can attend, the services companies can provide, and the way people can use their land. Getting it right is important but also difficult due to the knowledge problem. While the knowledge problem does not have a solution, it can be mitigated. In the private sector, prices, profit, and loss guide consumers and producers and the feedback these signals provide ensure that mistakes are corrected in a timely manner.
In contrast to the private sector, the public sector often lacks prices, profit, and loss signals, instead relying on static benefit-cost analysis. This makes the public sector more susceptible to mistakes and makes it more likely that any mistakes are long lasting. But even in the public sector, a heightened awareness of the knowledge problem can lead to beneficial change.
We hope readers of our volume, Informing Public Policy, get a better understanding of the knowledge problem while also recognizing that there is room to improve current policies and the policy-making process despite its pervasiveness.
 School Funding Fairness from the Education Law Center and Rutgers Graduate School of Education http://www.schoolfundingfairness.org/
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Adam A. Millsap is the assistant director of the L. Charles Hilton Jr. Center at Florida State University and an affiliated scholar with the Mercatus Center at George Mason University. He is co-editor, along with Stefanie Haeffele and Abigail Hall, of Informing Public Policy: Analysing Contemporary US and International Policy Issues through the Lens of Market Process Economics.