Welfare economics and the foundations of CBA
This chapter examines the foundations of cost–benefit analysis (CBA) as they exist in the theorems of welfare maximization. It defines the necessary conditions of welfare maximization and the situations in which even a perfectly competitive market fails to promote optimality, creating thereby a need for government intervention and a consequent case for the use of CBA. The chapter also examines alternative rules proposed for the guidance of public decision makers in their efforts to promote social welfare through the use of CBA. It emphasizes that in the absence of externalities, public goods and increasing returns, the equality of price and marginal cost is a sufficient condition for the achievement of economic efficiency. The chapter also defines the three conditions of Pareto optimality: efficiency in exchange, efficiency in production and efficiency in both exchange and production. It finds an inadequate level of fire or police protection if these services are provided entirely through the private market.