The Compensation Principle and Cost Benefit Analysis: Consistency, Application and Decision Rule Error

Evaluating projects on the basis of aggregate (unweighted) costs and benefits is a wide spread practice in cost-benefit analysis. This practice continues despite serious flaws in the "compensation principle", which is the usual welfare theoretic basis to justify the procedure. For this reason we examine precise conditions under which projects can be evaluated in terms of aggregate costs and benefits. We also examine the direction of the bias or decision rule error that will be encountered when the required conditions are not satisfied.