Chapter 6

Economic and Social Analysis

1
• Economic analysis of projects is similar in
form to financial analysis in that
 both assess the profit of an investment.

• The concept of financial profit, however, is not

the same as the social profit of economic
analysis.

• The financial analysis of a project identifies

the money profit accruing to the project
operating entity,
2
• whereas social profit measures the effect of a
project on the fundamental objectives of the whole
economy.

• These different concepts of project are reflected in

the different items considered to be costs and
benefits and in their valuation.

• Once financial price for costs and benefits have

been determined and entered in the project
accounts, the analyst estimates the economic value
of a proposed project to the nation as a whole.

3
• The financial prices are the starting
point for the economic analysis;
they are adjusted as needed to
reflect the value to the society as a
whole of both the inputs and outputs
of the project.

4
• When the market price of any good or service
is changed to make it more closely represent
the opportunity cost (the value of a good or
service in its next best alternative) to the
society, the new value assigned becomes

the “shadow price” or “accounting

price” or “economic price” or
“efficiency price”.

5
• In addition to adjustments made to correct market
distortions and market imperfections,
the adjusted price could further be weighted to
reflect income distribution and savings objectives.

• Financial appraisal of a project may result a

negative NPV but might render positive NPV when
it is viewed form societies point of view - economic
analysis.

6
• The project’s economic variability will be
undermined if financial viability is not ensured
and
expenditures for operations and maintenance
will inevitably suffer.
• For projects that are justified because of their
positive economic net present value, then,
analyst must show explicitly
The financial NPV & economic NPV
The amount of the financial short fall and the
sources of funds to finance it; and
The sustainability of the arrangements. 7
 6.1 Purpose of Economic Analysis

1. Selection of alternatives
2. Identification of winners and losers
3. Fiscal impact
4. Environmental impact

8
 6.1 Purpose of Economic Analysis …
1. Selection of alternatives

 to help design and select projects that contribute

most to the welfare of a country.

 When used solely, economic analysis serves only a

very limited purpose and hence should not be the
only basis for financial decision.

 Optimal decision must be made based on the relative

merit of all aspects (financial, economic, fiscal
impact, environmental impact, etc.)
9
 Selection of alternatives…
• The tools of economic analysis can help us
answer various questions about the project’s
impact on
• the entity undertaking the project, on society,
on the fiscal impact and on various
stakeholders, and about the projects risks and
sustainability.

10
Purpose of Economic Analysis…
2. Identification of winners and losers
• A good project contributes to the country’s
economic output; hence it has the potential
to make everyone better off.
• Nevertheless, normally not everyone
benefits, and someone may lose.
• Moreover, groups that benefits from a
project are not necessarily those that incur
the costs of the project.
11
 Purpose of Economic Analysis…
• Identifying those who will gain, those who
will pay and those who will lose gives the
analyst
insight into the incentives that various stake
holders have to see that the project is
implemented as deigned.

12
 6.1 Purpose of Economic Analysis…
6.1.3 Fiscal impact

• How and to what extent will the costs of the

project be recovered from its beneficiaries?

• What changes in public expenditures and

revenues will be attributable to the project?

• What will be the net effect for the government?

13
6.1 Purpose of Economic Analysis…
6.1.4 Environmental impact

• A very important difference between society’s

point of view and the private point of view
concerns costs (or benefits) attributable to the
project but not reflected in its cash flows.

• The effects of the project on the environment,

both negative (costs) and positive (benefits),
should be taken into account and if possible,
quantified and assigned a monetary value.
14
 6.2 Numéraire
• The choice of currency and price level in which
to conduct the analysis must be decided first.

• Financial analysis is usually conducted in the

currency of the country undertaking the project
and at the prevailing market prices.

• Economic analysis can be conducted in domestic

or foreign currency and at domestic market price
or at border price
15
 Numéraire…
• However, when financial analysis is done in one
unit of account and the economic analysis in
another, the difference between the financial
and the economic values have no meaning.
•Since comparison of financial and economic analysis
conveys much information as gainers and losers, fiscal
impact, extent of externalities, extent of market distortions
& their policy implications, etc,

 it is advisable to use same (domestic) currency in both

financial & economic analysis.

16
 6.3 Valuation and shadow prices

• The value of inputs used up (costs) and outputs

produced (benefits) of a project depend on
value judgments by government, as well as
on technical and behavioral parameters and
on the resource and policy constraints.

17
 Valuation and shadow prices…

• Value judgments by the government determine

the weight to be given
to future consumption relative to present
consumption: that is, to growth as against present
consumption,
to benefits for different classes of income recipients or
different regions; and
 to future employment relative to present employment.

18
 Valuation and shadow prices …

• Therefore, shadow or efficiency or economic

prices can be defined as
 the value of the contribution to the country’s
basic socioeconomic objectives made by any
marginal change in the availability of
commodities or factors of production.

19
 6.4 Economic and social cost benefit
analysis
• A project will be profitable to society

 if the economic/ social benefits of the

project exceed the economic/ social costs

 or to put in another way, if the net present

value of the project to society is greater than
zero.
20
Economic and social cost benefit analysis…
• How should a project’s economic/ social
benefits and costs be measured, and what
common unit of account (or numéraire) should
the benefits & cots be expressed in, given a
societies objectives & the fact that it has
trading opportunities with the rest of the world
so that it can sell and buy outputs & inputs
abroad (so that domestic & foreign goods will
be made comparable)?
•Broadly, there are two methods of measuring
economic costs & benefits of a project 21
 Economic and social cost benefit
analysis…
• two methods of measuring economic costs &
benefits of a project are:
1. UNIDO approach and

2. Little-Mirrlees approach.

22
 6.5 Approaches of measuring economic costs &
benefits of a project

• There is conceptual difference between social

costs - benefits and economic cost - benefit
analysis.

The results of social cost-benefit analysis may

diverge from the results of economic cost-benefit
analysis.
23
 Approaches of measuring economic costs
& benefits of a project …

• Economic costs and benefits when they are adjusted

to consider other objectives of society as
distributional consequences & other objectives, they
become social costs & benefits of a project.

• If the market prices are adjusted only for market

distortions of various kinds; direct transfer payments
& externalities, it is simply economic cost-benefit
analysis.
24
 Approaches of measuring economic costs & benefits
of a project …

• Hence, economic cost benefit analysis limits itself

only to the analysis of effects of a project on real
national income of the country.

• Some analysts simply adjust financial costs &

benefits into efficiency prices and leave other social
aspects for subjective judgments.

25
Approaches of measuring economic costs &
benefits of a project …

• Some others recommend evaluating proposed

projects first by using essentially the same
efficiency prices then
 by further adjusting these prices to weight
them for income distribution effects & for
potential effects on further investment of the
benefits generated.
26
Approaches of measuring economic
costs & benefits of a project …
• Still some others, Little and Mirrlees (1974), &
UNIDO Guidelines for project evaluation
(1972a), propose evaluating the project

first by establishing its economic accounts in

efficiency prices then by adjusting these accounts
to weight them for income distribution and saving
effects.

27
 Approaches of measuring economic costs &
benefits of a project …
• Making allowance for the effect of a project on
income distribution & saving, however,
involves
somewhat more complex adjustments
than those necessary to estimate
‘efficiency’ prices and it also
unavoidably incorporates some element
of subjective judgment.
28
 6.5.1 UNIDO Approach

• In this method shadow exchange rate (SER) is used

 to made adjustment for divergence

between market prices and economic
values, and also
 to make comparable domestic and foreign
resources

29
 UNIDO Approach…
• In this method, if commodities are traded,
first all these traded goods will be adjusted for any
distortions in the domestic markets.

after this adjustment is made the adjusted domestic

price will be multiplied by SER to make domestic
resources be comparable with foreign resources.

30
 UNIDO Approach…

• The easiest way for adjusting domestic

market distortions is
 to use border prices, c.i.f., for imports
and f.o.b. for exports and then multiply
this border price expressed in foreign
currency by SER to arrive at economic
border prices.

31
 UNIDO Approach…

• But, if the commodities are non-traded, i.e.

if f.o.b. prices are less than domestic prices
& domestic prices less than c.i.f. prices and
if the market prices are good estimates of
opportunity cost or willingness to pay,
we directly take the market price as
economic value of the item.

32
 UNIDO Approach…

• But if the prices of non-traded items (goods

and services or factors of production) are
distorted,
we will adjust the market price to eliminate
distortions and then use these estimates of
opportunity cost as the shadow price to be
entered in the economic analysis.

33
 UNIDO Approach…
• Example:
• Suppose we have a project producing export
item that uses both foreign & domestic
inputs.
 The net benefit (ignoring discounting) would
be estimated as:
Net benefit  SER X - M   D

34
 UNIDO Approach…
• Where
X - border price of exports in foreign currency
M - border price of imported inputs in foreign
currency
D - adjusted (economic) values of domestic inputs
in domestic currency
SER - is the shadow exchange rate (assuming the
official exchange rate does not accurately
reflect the true value of foreign currencies to
the economy).

35
 UNIDO Approach…
Shadow Exchange Rate
• The need to determine the foreign exchange
premium arises because in many countries, as
a result of national trade policies (including
tariffs on imported goods & subsidies on
exports), people pay a premium.

• This premium is not adequately reflected when

the price of traded goods are converted to
domestic currency equivalent at the official
exchange rate. 36
 Shadow Exchange Rate…

• The premium, thus, represents the additional

amount that users of traded goods, on average
& throughout the economy are willing to pay
to obtain one more unit of traded goods.

37
 Shadow Exchange Rate…

Pd
SER 
Pw

Where Pd - domestic price

Pw - world price in foreign currency

38
 Shadow Exchange Rate…

• To derive an average and representative

estimates of SER that can be applied across all
traded goods, we need to take the weighted mean
of relative value of all imported & exported
goods. Thus:

n
 Pdi 
SER   f i  
i 1  Pwi 
fi -the weight of the ith good 39
 Shadow Exchange Rate…

• The weights (fi) are a function of the quantities

imported and exported and of the elasticities of
demand for the various imports and the
elasticities of supply for the various exports.

m PEDi  QDi
fi 
 PEDi  QDi  PES i  QSi 
X PES i  QSi
fi 
 PEDi  QDi  PES i  QSi  40
 Shadow Exchange Rate…
Where
fim
- is weight of the ith import good
x
f i -is weight of the ith export good
PEDi - is price elasticities of demand of the ith
import
PESi - is price elasticities of supply of the ith export
Qdi - is quantity imported of the ith good
Qsi - is quantity exported of the ith good

41
 6.5.2 Little-Mirrlees Approach
• It was thought that if a project was analyzed at
world prices, this would give an indication
 first of whether it could survive in the
long term in the face of international
competition, and
secondly of whether its output could be
obtained more cheaply from international
sources.

42
 Little-Mirrlees Approach…
• If world prices are used, the economic
price at which to value a project’s output
is
 its export price if it adds to exports; or
 its import price if domestic production
leads to a saving in imports (import
substitution).

43
 Little-Mirrlees Approach…
• Similarly, on the cost side, the price at
which to value a project input is:

its import price if it has to be imported, or

export price if greater use leads to a
reduction in exports.

44
 Little-Mirrlees Approach…
• The above adjustment applies for
traded goods (imported or exported
goods).

• But if the goods or inputs in question are

non-traded goods,
 the analyst needs to use conversion
factor to translate domestic prices into
their border price equivalent. 45
 Little-Mirrlees Approach…
• A conversation factor (CF) is the ratio of the
economic (shadow) price to the market price,
that is:
Economic price
CF 
Market price
 Economic price  CF(Market price)
 So the economic price for a non-traded
good is its market price multiplied by the
conversion factor. 46
 Little-Mirrlees Approach…
• How are conversion factors derived?
• The true cost of any good is its marginal cost
to society.
• In principle, to find the world price of non-
traded goods, each good could be
decomposed into its traded and non-traded
components in successive rounds -
backwards through the chain of production.
47
 Little-Mirrlees Approach…
• In practice, however, it is not feasible to
differentiate conversion factors between all
non-traded goods and only special outputs
(and inputs) are treated this way because the
procedure is difficult, time consuming and
costly.
therefore, Shortcuts are needed that
provide a reasonable approximation.
48
 Little-Mirrlecs Approach…
• In essence, all the shortcuts involve some
degree of averaging for a group of non-
traded items and,
therefore, some degree of error if average or
standard conversion factor is applied to a
particular non traded good rather than its
own specific conversion factor.

49
 Little-Mirrlecs Approach…
• The derivation is as follows:
SCF .Pd  Pw .OER
P w OER 
SCF 
Pd
Where Pd = domestic price in domestic
currency
Pw = world price in foreign currency
OER = official exchange rate
SCF = standard conversion factor

50
 Little-Mirrlecs Approach…

1
SCF 
Pd
Pw OER 

Pd is the shadow exchange rate i.e., the price of

Pw goods in domestic currency relative to their world
prices
1 1
SCF  
SER PF
OER

SER
OER
is the shadow price of foreign
exchange (PF)
51
 Little-Mirrlecs Approach…

SER  1 
PF   SER  
OER  OER 
Pdi  1   Pdi 
 fi   f i  
Pwi  OER   Pwi OER  
Where f i - Weights for the ith commodity
Pdi- domestic price of the ith commodity
in domestic currency
Pwi- world price of the ith commodity in
foreign currency
PF- shadow price of foreign exchange52
 Little-Mirrlecs Approach…
• Taking the following example can summarize
Little-Mirrlees approach of adjusting domestic
prices into economic prices.

• A project that produces export goods can be

assessed as follows:
Net Benefit= OER (X-M) - SCF.D

53
 Little-Mirrlecs Approach…
Where -OER- official exchange rate
X- exported goods in foreign currency
M- imported goods in foreign currency
SCF- standard conversation factor
D- price of non-traded goods in domestic
currency

54
 Little-Mirrlees Approach…
• To summarize, as long as SCF is the ratio of
OER to SER, the two approaches - UNIDO
and Little-mirrless - differ :
only to the extent that SER is different
from the actual exchange rate.

55
 6.6 Economic export and import parity price

• Export Parity Price

• Suppose a product is produced and exported to Canada,
then its export parity price is calculated as:
C.i.f. at point of import (say, Canada port)
Deduct- unloading at point of import
Deduct- freight to point of import (in this case air
freight)
Deduct – insurance
Equals – f.o.b. at point of export (A.A)

56
 Export Parity Price ….
• Convert foreign currency to domestic currency
at official exchange rate (OER) if you are
using the L-M approach or shadow exchange
rate (SER) if you are using UNIDO approach
• Deduct - local port charges
• Deduct - local transport & marketing (if not
part of project) at their economic price and
multiply it by SCF in L-M approach
• Equals export parity price at project boundary

57
 Export Parity Price ….

• Deduct - local storage, transport &

marketing costs (if not part of project cost) at
their economic price and multiply it by SCF in
L-M approach
• Equal economic export parity price at project
location (farm gate)

58
 Import Parity Price
• F.o.b. price at point of export
• Add-freight charges to point of import
• Add-insurance charges
• Add- unloading from ship to pier at port
• C.i.f. Price at the harbor of importing
countries
• Convert foreign currency to domestic one
(multiply by OER) if you use L-M approach
and SER if you use UNIDO approach

59
 Import Parity Price …
• Add-local port charges
• Add-transport & marketing costs to relevant
wholesale market at economic price and
multiply it by SCF in L-M approach
• Equal price at wholesale market
• Deduct-local storage & other marketing costs
at economic price and multiply by SCF in L-M
approach (if not part of project cost) –this is
the marketing margin between central market
and the project site.
60
 Import Parity Price …

• If the project uses imported inputs, we have to

add this cost to the project.
Equals economic import parity price at project
location (Farm/project gate price)

61
 6.7 Valuation of non-traded goods
• Non-tradable items are those which are not traded
internationally.

• They include items such as

services where the demander and producer must be in the
same location, and
commodities which have low value relative to either their
weight or volume.

•In such cases the transportation charges prevent

producers from profitably exporting their goods.
62
Valuation of non-traded goods …
• Typically, non-tradable goods include such items as
 water supply,
 all public services,
 real estate,
 construction,
 local transportation;
 goods with very high transportation costs such as
gravel; and
 commodities produced to meet special customs or
conditions of the country.
 ETC
63
 Valuation of non-traded goods…

• If determination of price takes place in the

world market, the good should be considered
tradable.

• If the setting of the price takes place by supply

and demand in the local market, the good
should be considered non-tradable.

64
 Valuation of non-traded goods…
• valuation of non traded goods will mainly depend on
such factors as:
 quantity of input demanded and output supplied vis-à-vis
total demand and supply;
 elasticity of demand and supply both in the short run and
long run;
 market imperfections;
 government intervention of different kinds;
 taxes and subsidies that are targeted to compensate
external costs (or benefits) and
 other indirect taxes, subsidies and price controls targeted
for some other purposes. 65
 6.8 Valuing Output Using Market
Prices
• When a project adds to the supply of consumer
goods, the willingness to pay for the output of the
project may be measured, by the market price
provided the following conditions are satisfied:

1. There is competitive buying in the market place

2. The additional supply contributed by the project
leaves the market price unchanged.

66
 Valuing Output Using Market
Prices…
•However, these conditions would not in most
cases be satisfied and using market prices to value
project outputs would be biased.

Taxes, externalities and other standard market

distortions must be accounted for correctly.

67
 Valuing Output Using Market
Prices…
• There are three effects when a project supplies
its output to the market:
1. The market price of the output may fall as a
result of the increase in supply;
2. Other private producers may wind up
supplying less of it because of the reduced
price; and
3. Consumers of the output may purchase more
of it if price declines.
68
 Valuing Output Using Market Prices…
• Both the decreases in private (others) production
and the increase in consumption of the output are
part of the project’s benefits.

• The former is considered a benefit from social

point of view because
some resources will be free to be allocated for
some other use somewhere else in the economy
(assuming no business shut-down and workers lay-
off as a result of the project).
69
 Valuing Output Using Market
Prices…
• And, the latter is a benefit because
consumers are getting more of goods or
services that they value.

70
 Valuing Output Using Market
Prices…
• The relative sizes of decreased production and
increased consumption will depend on the
relative elasticities of supply and demand.

• If demand is relatively elastic and supply

relatively inelastic then the extra output generated
will go mostly to increased consumption.

71
 Valuing Output Using Market
Prices…
• If on the other hand, demand is relatively
inelastic and supply relatively elastic then
the project’s output will result in reduced
private production.

72
 Valuing Output Using Market Prices…
• Proper valuation of the project’s output can be
summarized in two rules:
1. The increase in consumption of the output should
be measured according to consumers’ willingness
to pay for that output (which is an indication of
MU and measured by demand curve)

2. The decrease in private production of an output

should be measured according to producers’
marginal cost of the decreased production.
73
 Valuing Output Using Market Prices…
•The original supply
P and demand curve
S=MC are S & D.
• The project
Sp increases supply of
Po

Pp the output from S to Sp

Value of increased
consumption
Value of D
decreased private
Qr Qp
production Qo Q

Fig. 6.1. Value of output of a project when markets are competitive

•QoQr – quantity of decreased production
•QoQp – quantity of increased consumption
•The sum of the above two (i.e. QPQr) is the total quantity
produced by the project.

We can apply these principles to a variety of conditions

74
 6.8.1 Valuing Output when markets are relatively
competitive

i. Relatively large quantities

• The supply of project’s output to the market
will shift the supply curve to the right, and
hence, result in a fall in equilibrium price.
This will - increase consumption; and
- decrease the sales of those producers that are
outside the project.

75
 Relatively large quantities….
• Thus, the total value of project’s output is

the sum of incremental consumer’s surplus

(willingness to pay) and the net reduction in
cost of production of other firms.

 The total value of output is equal to the project’s

output (QpQr) multiplied by the average of the
before and after prices.
76
 Relatively large quantities….
• In estimating the price effects of large
projects,
one approach is to use an estimate of the
price elasticity of demand and the price
elasticity of supply.
The percentage price decrease(%ΔP) likely
to result from a project can be calculated
using equation (7)
77
 Relatively large quantities….
%Qd
PED 
% P
%QS
PES  ...1
% P
PED – price elasticity of demand
PES – Price elasticity of supply

Qd  Qs  Qp.......... ....2

Qd  additional consumptio n
Qp  project ' s total output
Qs  reductionin production
78
 Relatively large quantities….
• If we divide the above by equilibrium output
(Q0) without the project, then
 Qd  Qs  Qp
  ... 3
Q0 Q0 Q0
 %  Qd  %  Qs  %  Qp
% Qd  % P.PED.......... .......... .......... ...4
% Qs  % P.PES .......... .......... .......... ....5
% P.PED  % P.PES  % Qp.......... .6
79
 Relatively large quantities….

% Qp
 % P  ..................7
PED  PES
Thisis percentage decrease in price due to the project

80
 Example:
• A job-training program will involve setting up a
factory to produce bicycles that will be sold locally.
In the local bicycle market, there are usually 10,000
bicycles sold per year. The quantity of bicycles the
project is expected to produce each year is 1500, or
about 15% of the local market. Economists
estimated that the price elasticities of supply and
demand in the local bicycle market are 0.8 and 1.3,
respectively. The issue for analysis of the project is
what value should be attached to the bicycles
produced. To calculate the percentage decrease in
the price, the formula would be: 81
 Qproject
Q 0.15
%p    0.071
PED PES 1.3 0.8
So, the price of bicycles could be expected
to fall by about 7.1% as a result of the
project. To use this information in valuing the
bicycles produced, we need to know the
price of bicycles before the project. Imagine
that the median price of bicycle was 400B.
Based on this, the price of bicycles after the
project starts operating will be
82
• PA = 400 x (1 - 0.071) = 371.60 B
• And the correct value to attach to the bicycles
produced by the project would be the average
of the before price (400B) and the after price
(371.60B) or 385.80B
•

83
• It is probably worth nothing two points here.
First, taking the simple average price assumes
that both the demand and the supply curves are
linear.
 Second, if the analysis is financial analysis,
which views the project from the owner’s
perspective, the price will be the lower price
(actual price after the project) because here the
analyst objective is to calculate the actual
revenue of the firm.
84
 ii. Relatively small quantities

• If the project will produce a relatively small

quantity of the output, its price will not change
significantly
therefore, the market price prior to
the project can be used as the value of
the output.

85
 6.8.2.1.Valuation of outputs when distortions
exist

Valuation of outputs when there are taxes

• Many goods are subjected to taxation and the

valuation technique of these goods is slightly
different from untaxed goods.

• Taxes should be included in the value of increased

consumption but not in the value of decreased
private production.
86
 Valuation of outputs when there
are taxes …
• Private consumers will purchase additional
units of the output until their marginal value
declines to the price including tax, because this
is the price that consumers must pay.

87
 Valuation of outputs when there
are taxes…
• The private suppliers of the output, on the other
hand, will produce additional units until the
marginal cost rises to the price they receive, but this
price will not include taxes.

Any reduction in private production should be

valued at the marginal cost of production,
which will be equal to the market price less
taxes. 88
 Valuation of outputs when there
are taxes…
• The tax that would have been paid on the sale of
these additional units is merely a reduced transfer
to the taxing authority and is neither a cost nor
benefit as long as the taxing authority has standing.

89
 Valuation of outputs when there are taxes and
relatively large quantities

• If the project produces relatively large

quantities,
 this means that some producers of the output will
reduce their production and
 that some consumers of the output will increase
their consumption. (Fig.6.2 depicts this situation)

90
 Valuation of outputs when there are taxes and
relatively large quantities…
P

St = MC after tax

Sp

S = MC
Po

Pp

Value of increased consumption

Reduced cost of decreased

private production
D

Q
Qr Qo Qp

Fig. 6.2 Value of output when there are taxes and output of the project is relatively
large 91
 Valuation of outputs when there are taxes and
relatively large quantities…
• Taxes should be included in the value of the increase
in consumption because the private willingness to
pay includes the tax on the good.
• In contrast, taxes should not be included in the value
attached to decreases in private production
 because they are not part of the cost of the resources
that would have been used to produce the output.

92
 Valuation of outputs when there are taxes and
relatively large quantities…

• Fig. 6.2 illustrates the impact of a project on

the market for a taxed output.
• The original supply curve is given by S= MC,
not including taxes.
• The effect of the tax is to shift the supply curve
to St = MC of production plus tax.
• The effect of the project on the supply curve is
shown as an increase in supply and hence
shifts the supply curve from St to Sp.
93
 Valuation of outputs when there are taxes and
relatively large quantities…
The effect of the project on the supply curve may
be either larger or smaller than the effect of the tax.

• The right side of the shaded area shows the value of

increased consumption of the output and is valued
according to consumers’ willingness to pay.
• The left side of the shaded area shows the value of
the reduction in private production and is valued
according to procedures’ marginal cost.
94
 Valuation of outputs when there are
taxes and relatively large quantities…
• To calculate the value of this output,

the increase in consumption should be multiplied

by the average of the pre-and post-project prices
including the tax and

 the decrease in production should be multiplied

by the average of the pre-and post-project prices
excluding the tax.
95
 Valuation of outputs when there are taxes and
relatively large quantities…
• The most difficult part in this valuation will likely
be determining
how the project’s output will be divided between
reduction in private production and increases in
consumption.

The key to determine this is some knowledge of

the elasticities of supply and demand for the good
in question.

96
 Valuation of outputs when there are taxes and
relatively large quantities…

• If reliable estimates of the supply and demand

elasticities are available, the changes in the
quantities supplied and demanded may be
estimated by the following equations.

97
 Valuation of outputs when there are taxes and
relatively large quantities…
% QP
% P 
PED  PES
% Qs
PES 
% P
% Qs
 % p  Substituti ng this in the first equation
PES
%  Qs % Qp

PES PED  PES
% Qs PES
  this is percentage
%  Qp PED  PES
reduction in private production
98
Valuation of outputs when there are taxes and
relatively large quantities…
• %P = percentage change in price
• %Qs =percentage change in quantity supplied
%Qd = percentage change in quantity demand

• PES = price elasticity of supply

• PED = price elasticity of demand
• Similarly change in quantity demanded for a
change in price can be estimated by the
following formula.
99
 Valuation of outputs when there are taxes and
relatively large quantities…

dQd PED
 this is percentage increase
dQp PED  PES
in consumption

100
 Exercise
1. An experimental project investigating large-scale
wine production in Awash will produce 120,000
cases of a rare variety of wine. Wine is subjected to
a tax of 20%/case.
• Qd = 600,000 – 2,000p
• QS = 3000P – 60,000
a)Find the total value of wine that will be produced
by the project.

101
 b. Assume you have no knowledge of the supply and
demand curve of the product. But from previous
studies, the demand and supply elasticities are 0.78
and 1.18. respectively. Further the current, without
project equilibrium price and quantity are given by,
132B & 336,000 cases.

• Determine the additional consumption and

reduction in private production.

102
 6.8.2.2.When there are other inefficiencies

i. Monopolist with market power

• If a firm or firms are enjoying monopoly power
without the project it is likely that the market price
is above the MC.
• The following figure shows a monopolist with
marginal cost curve MC supplying to the market
with demand given by D = MV.
• The profit maximizing quantity Qo will be
determined by the intersection of the marginal
revenue curve with the MC curve. 103
 Monopolist with market power…
• The price, as given by the demand curve at this
quantity, is Po.

• The effect on the monopolist of the sale of a

project’s output will be a reduction in the demand
faced by the monopolist.
• This reduction in the monopolist’s demand is
shown as a shift of the demand curve from D =
MV to Dp.
104
 Monopolist with market power…
• At the new, lower demand curve, the monopolist
will choose to supply the smaller quantity Qp at
price P1.
• The reductions in the monopolist’s costs are given
by the left hand section of the shaded area and are
valued along the MC curve.
• The total output increases from Qo to Qt and the
value of the additional consumption is the right
hand side of the shaded area.

105
 Monopolist with market power…
P

MC

Po

Pp

Value of increased
consumption
Reduction in D = MV
monopolist cost of Dp Q
production Qp Qo Qt

MRp

MR

Fig.6.3 Valuation of output when there is market imperfection

106
 ii. Outputs Subjected to Price Controls

• When outputs are sold in markets subject to price

controls, there is no guarantee that market prices
will reflect
either suppliers’ opportunity costs of production or
 consumers’ marginal willingness to pay.

107
 Outputs Subjected to Price
Controls…
• If there is an effective price ceiling on an output
there is likely to be a shortage,
with the implication that the marginal value of an
additional unit of output is higher than the
controlled price.
• In this case, the official price at which the ceiling
is set is too low to use for a proper valuation.

108
 Outputs Subjected to Price Controls…

• The marginal willingness to pay on the part of

consumers is likely much higher.

It may be estimated by black market

prices, if these can be reliably determined.

109
 Outputs Subjected to Price Controls…

• Alternatively, the analyst can add the average

value of waiting in line to the controlled price
so that it might give an estimate of the
marginal willingness to pay on the part of
private consumers.

110
 Outputs Subjected to Price Controls…

• Fig. 6.4 shows a situation in which a good is

subjected to a price ceiling of 5Birr, with the
result that 400 units are supplied to the market,
but at this quantity consumers’ marginal value
or marginal willingness to pay is 20Birr.

• The output from a small project that produced

and sold one unit of this good should be valued
at more than the 5Birr-ceiling price.
111
 Outputs Subjected to Price Controls…

P S
20

5
D
0 400 120,000 Q
Fig. Outputs Subjected to Price ceiling
112
 Outputs Subjected to Price
Controls…
• Similarly, if a project's output is subject to
an effective price floor maintained by some
system of price supports,
the appropriate value to attach to this output
can be difficult to determine

113
 6.9 Valuing non-traded inputs
• There are three implications of using inputs in a
project.
First, the market price of the input may rise as a
result of the increase in demand for that input.

Second, other consumers of the input may wind

up using less of it because the project has taken
some of the input out of the market.

Third, producers of the input may make more of

it to cover the additional demand of the project.114
 Valuing non-traded inputs…
• The relative sizes of decreased private consumption
and increased production will depend on the
relative elasticities of supply and demand.

• Both the decrease in private consumption and the

increase in production of the input are costs of the
project.

115
 Valuing non-traded inputs…
• The decrease in private consumption is a cost
because individuals will be consuming less of a
good or service they desire.

• The increase in production is a cost because

productive inputs will be shifted from other
activities toward increased production of this
input.

116
 Proper treatment of input costs can be
summarized in two rules:

•The reduction in private use of an input should be

measured according to the willingness to pay by
other consumers of that input.

•The increase in production of an input should be

measured according to the marginal cost of the
additional production.

These rules are illustrated in fig 6.5 below

117
 P

S
P
o

Additional cost of
Pp increased production

Value of Dp
decreased D
consumption
Qp Qo Qt Q

118
• The relative sizes of decreased consumption
and increased production will depend on the
relative elasticities of supply and demand.
If demand is relatively elastic and supply
relatively inelastic, the increased demand
resulting from a project using an input is likely
to come mostly from decreased private
consumption and vise versa.

Valuation of inputs follows the same principle

discussed in the valuation of outputs of the
project in the preceding chapter. 119
• It is important to remember, however, that in
valuation of inputs used by the project will
affect
the social marginal benefit (demand curve) to
deviate from the market demand curve as
opposed to deviation of the social marginal
cost from the market demand curve in the
project’s output.

120
6.10 Tradable but nontraded items
• This can lead to difficult choice when the analyst
must evaluate the real effects on resources of a
project that involves items that could be traded
but probably will not be because of government
regulation.

These items, which are ''tradable but non-

traded'' across national boundaries are valued as

nontraded. 121
 Tradable but nontraded items…
• This is because project analysis must be made based
on 'positive economics' - what it is, as opposed to
'normative economics - what it should be.

Thus, the project analysis must be carried

out within the framework of economic
policies set by the government.

122
 Tradable but nontraded items…
• The project analyst must make the best judgment
about
what those policies are and will be, not just what
they ought to be, and work the economic analysis
accordingly.
• Such items would usually be imported were it not
for an import quota, or an outright ban that is
enforced against them.
Their domestic price may well rise high above
the prevailing price on the world market.
123
 Tradable but nontraded items…
• These barriers might have been created for a
number of reasons.
• What ever the reason might be, these items
must be treated as non-traded good.

• If the question were to evaluate whether these

items should be traded freely or not,
 the analyst would treat these items as traded
items and would evaluate the relative
advantage of the trade policy.
124
 Tradable but nontraded items…

Of course, if the project analyst expects that

there will be policy changes in the future with
respect to the item, he can treat it as traded
good and use border price with appropriate
adjustment to parity price.

125
 6.11 Valuing Externalities
• The financial costs of the project will not include the
costs of the externality
• hence, an evaluation of the project based on private
marginal cost (PMC) will
understate the social costs of the project &
overstates its net benefits.
• In principle, all we need to do to account for the
externality is
to work with social rather than private costs and
benefits.
126
 Valuing Externalities…
• In practice, the measurement difficulties are
tremendous because
often the shape of social marginal cost (SMC)
curve, & hence its relationship to PMC curve, is
unknown.
also it is not always feasible to trace and measure
all external effects.

Nevertheless, an attempt should always be made

to identify them and if they appear significant, to
measure them. 127
 Valuing Externalities…
• When externalities cannot be quantified they
should be discussed in qualitative terms.

 In some cases it is important to

“internalize” externalities by
considering a package of closely related
activities as one project - that is, to draw the
“project boundary” to include them.

128
 Valuing Externalities…
• Drawing the “project boundary” to internalize
externality can be done in two ways:

1. the project can adopt a technology such as

pollution abatement technology that will reduce or
avoided externalities and

2. the project that is creating external damage can be

taxed so as to compensate affected groups in the
society.
129
 6.11.1 Methods of Valuing Environmental
Externalities
• Several methods are available to value
environmental externalities.
• Sometimes a project uses resources without paying
for them.
• For example a factory may emit soot that dirties
surrounding buildings, increasing their maintenance
costs.
The higher maintenance costs are direct result of
the factory’s use of a resource, air, that from its
points of view is free but that has a cost to society.
130
 Valuing Environmental
Externalities: Methods…
• Likewise, a new irrigation project may lead to
reduced fish catch or the spread of a disease.
this project makes certain groups better off but the
nature of the benefits is such that the project entity
cannot extract a monetary payment from them.
“externalities” are real costs and benefits
attributable to the project and should be included in
the economic analysis as project costs or as project
benefits.
131
Valuing Environmental Externalities:
Methods…
 The main problem with externalities is measuring
them although it is easy to identify externality.
 It is not easy to quantify and assign monetary
value to them
• Before choosing an appropriate method, it is
important to make decision on two points –
the boundary and
 time horizon to which the analysis will
be done. 132
Methods of Valuing Environmental Externalities …

Whenever we assess the internal benefits & costs

of a project, the boundaries are clear:
if the benefits accrue to the project entity or if the
costs are borne by the project entity, they enter
into the analysis.

When we assess the externalities of a project to

determine its impact on society, the boundaries
become blurred.
133
Methods of valuing Environmental Externalities …

Identifying externalities implies expanding the

conceptual and physical boundaries of the analysis.

How far to expand is a matter of judgment

and depend on each individual project.

134
Valuing Environmental Externalities: Methods…
The second decision concerns the time
horizon.

Like the projects physical boundaries, its

time horizon also becomes blurred when we
go from financial to economics analysis.

135
Valuing Environmental Externalities: Methods…

• A project’s environmental impact may not last

as long as the project or it may outlive it.

• If the environmental impact lasts less time than

the expected economic life of the project,
the effects can be included in the standard
economic analysis.

136
 Valuing Environmental Externalities: Methods…
• If on the other hand, the effects are expected to
last beyond the lifetime of the project, the time
horizon must be extended.
Preferably, this latter can be done by adding to
the last year of the project the capitalized value
of that part of the environmental impact that
extends beyond the project’s life.

•After boundary and time decisions are made,

the next step is to choose an appropriate method
of valuation of externalities.
137
 Valuing Environmental Externalities: Methods…
• Methods for measuring environment resource values
are:
1. Direct methods:
Market price
Contingent valuation
2. Indirect methods:
Travel cost
 Hedonic property value
Hedonic wage values
Avoidant expenditures
Contingent ranking
138
 Methods for measuring environment resource
values…
1. Direct methods:
a) Market price (direct) - if the costs or benefits
have a market price we directly take the
market price except in this case we may have
to adjust for any divergence between the
market and economic prices.
b) Contingent valuation - also called willingness-
to-pay.
This method provides a means of deriving
values, which cannot be obtained in more
traditional way. 139
 Methods for measuring environment resource
values…
Contingent valuation approach asks respondents
what value they would place on an external cost
or benefit.

• More complicated versions ask whether the

respondent would pay $X to prevent the external
cost or obtaining the benefits.

• The answer may reveal fair estimate of external

costs and benefits if the survey is managed
carefully. 140
 Methods for measuring environment resource
values…
• Contingent valuation method have the following
weaknesses especially if the respondents are passive
user or nonusers.
1. The tendency that the willingness to pay estimates to seem
unreasonably large;
2. The difficulty in assuring the respondents have understood
or absorbed the issues in the survey; and

3. The difficulty in assuring that respondents are responding to

the specific issue in the survey rather than reflecting warm
feeling about public-spiritedness or the 'warm-glow' of
giving. 141
 Methods for measuring environment resource
values…

Yet, if the survey is carefully managed the

Contingent valuation technique can give a good
estimate of these costs & benefits.

142
 Methods for measuring environment resource
values…
2. Indirect observable methods –

these are based on observable behavior because

they involve actual (as opposed to hypothetical)
behavior, and
they are indirect because they infer a value rather
than estimate it directly.

143
Methods for measuring environment resource
values…
a) Travel cost methods:
• This may infer the value of a recreational
resource (such as a sport, fishery, a park, a
waterfall, or a wild life preserve where visitors
hunt with a camera) by using information on
how much the visitors spent in getting to the
site to construct a demand curve for
willingness to pay for a ''visit day''.
This will enable the analyst to construct the
demand curve and also to value the above
resources. 144
 Methods for measuring environment resource
values…
b) Hedonic property value:
this method attempts to decompose the various
attributes of value in property into their
component parts.

• For example, it is possible to discover that all

other things being equal property values are
lower in polluted neighborhoods than in clean
neighborhoods.
145
Methods for measuring environment resource
values…
• Hedonic property value and Hedonic wages
approaches use multiple regression analysis to
'teas out' the environmental component of
value in a related market.

• The regression equations allow the analyst to

separate out the relationship between property
values and pollution.

146
Methods for measuring environment resource
values…
This relationship can then be used to produce a
willingness to pay for pollution reduction.

147
 Methods for measuring environment
resource values…

C) Hedonic wages approaches:

these are similar with the above except that
they attempt to isolate the component of
wages, which serves to compensate workers in
risky occupations for taking on the risk.

It is well known that workers in high-risk

occupations demand higher wages in order to
induce them to undertake the risks.
148
Methods for measuring environment resource
values…
d) Avoidance expenditures :
• these are expenditures that are designed to reduce
the damage caused by pollution by taking some
kind of averting or defensive action.
• An example would be
to install indoor air purifiers in response to an
influx of polluted air or
 to rely on bottled water as a response to the
pollution of local drinking water supplies,
buying ‘tents’ to protect oneself from mosquito
causing malaria, etc. 149
 Methods for measuring environment resource
values…

• Since people would not normally spend more to

prevent a problem than would be caused by the
problem itself
averting expenditures can provide a lower bound
estimate of the damage caused by pollution.

150
Methods for measuring environment resource
values…
e) Contingent ranking:
• in this method respondents are given a set of
hypothetical situations that differ in terms of
environmental amenities (pleasantness) available
and other characteristics the respondents are
presumed to care about,
and are asked to rank these situations in terms of
their desirability.

151
Methods for measuring environment resource
values…

These rankings can then be compared to see

the implicit tradeoffs between more of the
environmental amenity and less of the other
characteristics

 Example: these characteristics could be an

increase in price related to the product or loss
in some benefits related to it.

152
 6.11.2. Valuing human life

• One fascinating public policy area where

approaches of valuing externalities have been
applied is in the valuation of human life.
• How is life to be valued?
• The simple answer, of course is that life is
priceless but that turns out to be not very helpful.

Since the resources used to prevent loss of life are

scarce, choices must be made.
153
 Valuing human life…
• One method is to value the probability of death
resulting from a reduction in environmental risk
or from an improvement of a given service.

• In this case, it is not the life itself that is being

valued but rather
a reduction in the probability that some
segment in the population could be expected
to die earlier than otherwise.

154
 Valuing human life…
Example:
• If probability of death is expected to decline
from one out of 100,000 to one out of 150,000
due to reduction in environmental risk,
 this implies that the numbers of expected deaths
would fall from 10 to 6.67, if the total population
were one million.
• If each person is willing to pay, say Birr 5, for
this risk reduction, then the implied value of a life
is approximately Birr 1.5 million.
155
• 10-6.67=3.33 total reduction in death per million
people
• Each person’s willingness to pay for this
reduction in death is 5 birr
• 5birr /3.33 reduced deaths=1.5 Birr per reduced
death which is willingness to pay for each
reduction in death per person
• Total population paying 5 birr=1,000,000
• 1.5x1,000,000=1.5 million birr is the implied
value of a life
156
 Valuing human life…

• The other method, although not economically sound,

is ''human capital'' approach that estimates the
present value of future earning of an individual that
would be lost because of premature mortality.

• The difficulty arises when comparing estimates

between countries with very different income levels

157
 Valuing human life…
• Although most economists do not favor using this
method for project and policy analysis purpose, it is
often used to establish ex-post court settlements
related to death of a particular individual.

• The other method, as discussed previously, is the

wage differential approach or hedonic wage values.

158
 Valuing human life…

• In the absence of carefully done national

studies of the value of a statistical life,
 it is often best to present mortality data in
terms of the number of lives lost or saved
rather than in terms of a dollar value.

159
 Valuing human life…

• Valuations of externalities are costly undertakings if

one has to get reliable estimates of costs and
benefits.

Thus, the benefit of assessing these externalities

must justify the cost of assessments i.e., before such
assessments it is important to weight their intensity.

160
 6.12 Shadow Prices for Factors of
Production
6.12.1. The shadow wage rate
• For the valuation of inputs involved in
production, an assumption is required indicating
that
the price of any input should represent the
opportunity cost of that input.
This opportunity cost reflects the value of output
forgone when used in some other area of
production.
161
 The shadow wage rate …
• Labor, as an important input of production in
investment projects, should be valued at its
economic cost
in order to obtain a more efficient allocation of
labor in projects.
• In the estimation of the SWR,
foregone output is considered as the first
and most important component of the
measurement.
162
 The shadow wage rate…
• Assuming that labor is in fixed supply, a
project has to take it away from other
employment somewhere else in the economy.

Therefore, the use of labor in a project

prevents its use elsewhere

163
 The shadow wage rate…
• The foregone output of labor in its best alternative
use enters in the analysis as a major component
of the economic cost of using the labor.

The opportunity cost of employing labor in a

project can be related to the marginal productivity
of the labor in its previous job.

Therefore, obtaining information of the source from

which labor is drawn is important.
164
 The shadow wage rate…
When there is an increase in labor incomes, this
may give rise to higher consumption and
possibly some savings.

• If, at the margin, consumption is less valuable

than savings to society, this should be reflected
in the SWR and be included as a cost to society.

165
 The shadow wage rate…
• The labor employed in a project is actually
paid the amount of the market wage, not its
social value.
• If the wage paid to labor in the new job(C), is
more than the value of forgone output
elsewhere (M), and if she/he consumes all of
this wage, then the additional cost of hiring
labor to the society is equal to “C–M”.

166
 The shadow wage rate…

We may derive the optimal shadow wage by

making the cost of using an additional unit of labor
equal to the benefits. i.e
SMCL= SMBL

167
 The shadow wage rate…
SMCL= PA + (C - M)
Where:
SMCL -Social marginal cost of labor
PA - opportunity cost of labor
C-M - net increase in consumption
C- increase in consumption in industry
M - fall in consumption in agriculture as
labor migrates 168
 The shadow wage rate…
• The social benefit of the labor used on the
project
(C  M )
 SMBL = PI +
S0

• PI - marginal product in the project

(C  M ) - part of the increase in consumption that

S0 is valued
S0 - is the valuation of saving (or future consumption)
relative to present consumption
169
 PI +

The shadow wage rate…

• Labor should be employed up to the point where the
social marginal benefit is equal to the social
marginal cost i.e
(C  M )
PI   PA  (C  M )
S0
C M 
 PI  PA  (C  M )   
 S0 
 1 
 W  PI  PA  (C  M )1  
 S0 

This define the optimum shadow wage (W*) 170

 The shadow wage rate…
The shadow wage is equal to the loss of
agricultural output (PA), plus the net increase in
consumption (C-M) less that of the increase in
consumption that is feature as a benefit
which is (C  M )
S0
If S0 = 1, if society is indifferent between the present and
future consumption, then

W* = PA
171
 The shadow wage rate…
If PA = 0, W* = 0
• If S0 -  ,if society place infinite value of the
future and none on the present
W* = PA + (C-M)
Thus, shadow wage (W*) will lie between PA and W

Clearly the shadow wage will be somewhere between the

opportunity cost of labor on the one hand, and the industrial wage
on the other, depending on the relative valuation of saving and
consumption.

172
 The shadow wage rate…

t
C1 C2 C3 C4 Ct
(1  i )1

(1  i ) 2

(1  i ) 3
 
(1  i ) 4

t 1
(1  i )t
S0  
C0 C0
•Taking a time horizon acceptable to society,
 S0 measures the present value of the future
consumption gains arising from investment now,
relative to the current consumption sacrifice.

173
 The shadow wage rate…
• S0 - depends up on:
• Marginal product of capital
• The length of time (t) &
• The discount rate (i) chosen

174
 Example

• Consider a project in Ethiopia where the market

wage is 20Birr/day & all wages are consumed (C
= 20). The marginal product in agriculture is
5Birr/day (PA = 5) and workers consumed 5 Birr
of output in agriculture before working on the
project (m = 5). All goods are non-traded and the
SCF is 0.8. The relative valuation of future to
present consumption is 4 (So = 4). Calculate
shadow wage rate
175
 Shadow wage rate…
  1 
W   p A  C  m 1   SCF
*

  so  

  1 
  5  20  5 1    SCF
  4 

 3
  5  15 .  SCF
 4
 16 . 25 SCF
 W * 16.25 x 0.8 13

176
 Shadow wage…

• We multiply it by SCF to arrive at the foreign

equivalent of using more labor.

• The market price is 20, but the shadow price of

labor is 13.
 This will encourage the use of more labor on
projects

177
One critical consideration that should be made
here is that more employment on projects in
urban areas may bring immigration so that the
loss of output in alternative uses is greater than
the marginal product of the person employed.

For example of five extra jobs pulled in ten

extra people, the loss of output would be 2PA
(double the marginal product of labor in
agriculture). In this case the shadow wage
would be 17.
178
   1 
W   p A  C  m 1   SCF
*

  so  

=[10+(20-5)(1-1/4)]0.8
=[10+15(3/4)]0.8
=17

179
 6.13 Social Appraisal
Distributional considerations in project appraisal
• So far, we have ignored the effect of project choice
on the distribution of income.
• The distributional consequences of projects can be
included in the estimation of shadow wages
by altering the valuation of present to future
consumption (1/S0) – increasing the value if the
consumption gain is to the poor & decreasing the
value if consumption gain is to the rich.
180
 Social Appraisal…

The distribution weighted in relative valuation of

present to future consumption can be thought of
as being composed of two parts:
1. The value of marginal in relative consumption to
someone at a level of consumption, c, divided by
the value of marginal increase in consumption
accenting to someone at the average level of
consumption, c , denoted as
Wc

 d
W c
181
 Social Appraisal…

2. The value of marginal increase in consumption to

someone at the average level of consumption
divided by the value of marginal increase in
public income (saving). Let as denote this as


Wc 1

Wg S o

182
 Social Appraisal…

• Therefore, the distribution weighted relative

valuation of present versus future consumption
is

Wc W c d


W c Wg so
d
•The ratio be thought of as the trade – off b/n
s o
raising the consumption levels of the poor & accelerating
economic growth. 183
 Social Appraisal…
• Up to now it has been implicitly assumed that d =1
as if it is the average person who always gains
from projects or that the gains to all individuals
are value equally.
• If greater weight is given to the consumption
gains of the poor (d >1) than to the rich (d < 1),
however, the substation of d/so for 1/so will alter
the shadow wage

184
 Social Appraisal…

• In measuring shadow wage that considers

distributional consequence of a project
W * = PA + (c – m) ( 1 – d/so) if say d = 4 in the
previous example
W* = 5 + (20 -5) (1 – 4/4)
W = 5 x SCF = 5 x 0.8 = 4

185
 Social Appraisal…

Altering & high value to the benefit of the

project to the poor has made the social use of
labor virtually cost less and therefore much
more profitable to undertake from society’s
point of view.

186