Limits of economic analysis

Economic tools facilitate in the preparation of a robust urban plan and can help with making a city more resilient against crime and terrorism, but there are also some fundamental and methodological limits of economic analysis/tools that have to be considered.

Consequential focus
Economic tools such as the cost-benefit analysis assume a basic rationale that things are worth investing in if the positive effects outweigh the negative ones. This imposes an evaluation of costs and benefits with a focus on the consequences of the respective decisions. However, this guidance by consequences can violate fundamental rights (such as civil rights) and is irrespective of actions based on their “rightness” or “duty/obligation”.

An example: The aim of a social cost-benefit analysis is to select the project with the highest social cost-benefit ratio that will lead to a maximisation of wealth for society. But what if the planned expansion of a new airport will indeed increase the (economic) well being of a region, but at the same time will significantly reduce the quality of life for people living close to the airport? Put differently, does a society have the obligation to protect the rights of all its citizens (including future citizens) or only the present majority?

Assumed complete knowledge
Economic analysis tends to assume “completeness of knowledge” of all the effects and corresponding weights. Apart from the fact that the used techniques are an estimate rather than a precise measurement, there is the risk in daily practice that in search of completeness the economic analysis results in judgements that are without justification, which, according to Sen ,(an Indian economist and a Nobel laureate who has made contributions to welfare economics, social choice theory, economic and social justice, economic theories of famines, and indexes of the measure of well-being of citizens of developing countries) results in ignoring “the less exactly measured consequences or less clearly agreed values, even though they may be extremely important”. Examples of these often ignored consequences are the environmental effects, the effects on quality of life, etc.

An example: It is common practice for social cost-benefit analysis to place a monetary value on human life, for example, when assessing safety measures against terrorism or road safety. The question is, however, if it is possible to adequately value a human life based on a market valuation system.

Dominant market thinking
Economic effects are principally valued according to the market mechanism. However, for a lot of goods (public goods, the environment, etc.) and specific type of effects (e.g. external effects) there exist no markets. As a result, market valuation only admits a narrow class of values, neglecting, for example, distributional issues and changes in values as a result of changes in the urban environment.

Normative claim
In theory, economic science does not presuppose a policy preference and the outcomes of a cost-benefit analysis or economic impact study is not the decisive step in the decision-making process. In practice, however, both economists and the public decision makers have to be very careful not to regard the economic analysis as the final/normative step in the decision-making process, and to reduce the multidimensional realm of reality to a financial and market value based model of reality.

Related subjects

 * Economic output
 * Economic tools
 * Economic main page