The Cost–Benefit Model

Abstract

This chapter explains the cost-benefit model. Cost-benefit analysis is also known as rate of return analysis and is similar in principle to the procedure followed in ordinary investment project evaluation. The most important distinction is between a private and social rate of return. A private rate is estimated when the benefits and costs refer to the individual undertaking the investment. However, it is possible to relate the social costs and benefits of an educational activity, thus arriving at the social rate of return. If one accepts infinitely elastic demand functions for all types of labor, it follows that the elasticity of substitution between all pairs of skills and between labor and other factors of production is infinite as well. In other words, different amounts of labor skill mixes are consistent with the same relative wages and therefore the elasticity of substitution between the two kinds of labor is infinite. Rate of return analysis is based on observed market earnings. Therefore, for a social rate of return calculation one has either to assume that wages are equal to the value of the marginal product of labor, or apply shadow pricing.