Cost-benefit analysis: Dealing with the problems of indivisible projects and fixed budgets

The use of cost-benefit analysis in option appraisals in health care when the decision-maker is faced with indivisible projects and a fixed budget is examined. It is argued that the methods used to overcome the problem of indivisibilities, benefit-cost ratios and the net benefit method, are not suitable for choosing between alternative projects for two reasons. Firstly, the values of benefit-cost ratios are sensitive to the specification of costs and benefits, and the literature abounds with examples of averted costs being added to the benefits of a project or reduced benefits being interpreted as an additional (psychic) cost. We show that such erroneous specification can lead to a relatively inefficient project being accepted as efficient, and vice versa. Secondly, practical applications of CBA have been performed in the absence of budget constraints on available resources. We show that once budget constraints are recognised the shadow price of resources required to implement a project may be affected by the amount of resources remaining in the budget after implementation. Once the budget constraint is recognised, a project which initially appeared to be the most efficient can be rendered relatively inefficient. It is suggested that alternative uses of remaining (or residual) resources should be identified and evaluated, thus ensuring the maximisation of benefits from the use of an overall budget.