Updated: 06/03/2007
Lecture Notes
ECON 622: ECONOMIC COST-BENEFIT
ANALYSIS
Lecture Two
0
PRINCIPLES UNDERLYING THE
ECONOMIC ANALYSIS OF
PROJECTS
1
Introduction to Economic Analysis
• The financial analysis of a project focuses on its financial
attractiveness to its private investors.
• The economic analysis measures the impact of the project on the
entire society.
• An economic analysis of a project helps determine whether the
project increases the net wealth of a Country’s society as a
whole or not.
• A project with a negative economic net present value will serve
to shrink the economy rather than grow it. For example if $1000
investment and NPV equals to $ -270. Then the project uses
1000 of resources and only produces 730 of value.
2
Estimation of Economic Prices
•
Financial prices are market prices, which are affected by the
various tariffs, taxes, and subsidies.
•
Economic values may differ from financial prices because:
1. consumers valuation of an item may be greater than financial
price they pay eg. road usage, water.
2. financial costs may not be the true costs eg. Natural gas is sold to
electricity utility in Egypt at a financial price that is only 1/3 of
international opportunity cost.
•
Calculating the economic values requires an understanding of
how to integrate financial values, tariffs and taxes, handling
and transportation costs, and exchange rate distortions.
3
Commodity Specific Conversion
Factors (CSCF)
• Financial prices are market prices, which incorporate all the tariffs,
taxes, and subsidies.
• We use the conversion factor to convert each of the financial cashflow
into the economic cost or benefit in the economic resource statement
in the economic appraisal.
Economic Value
CSCFi =
Financial Price
• Suppose, the project is using (purchasing) cotton yarn, the relevant
financial price to the project would be the demand price, Pd, (the price
paid by the project). The financial price to the project is R22,239 and
the economic value is R18,794. The economic value is less than
financial price because the economic value doesn’t include tax.
CSCFCotton Yarn
R18,794
=
= 0.85
R22,239
4
Example of Financial and Economic
Cashflows: the Case of Electricity Project
Table of Parameters for Financial Analysis
Table of Parameters for Economic Analysis
Price of Electricity
Production of Electricity
2.20 Rs/Kwh Long term investment
1,500 Gwh/year Machinery
8000
Equipment
1290
Gas
0.25 per Kwh Financial Cost
Land (Given as subsidy) 300
of Capital
12%
Coal
0.15 Rs/Kwh
Cashflow: Financial Points of View (millions Rs.)
Year
2001 2002 2003
Inflows
Sales
3300 3300
Land (Subsidy)
300
Liquidation value of investment
Liquidation value of land
Total Inflows
300 3300 3300
Outflows
Land
Long term investment
Machinery
Equipment
Gas
Coal
Labor Wages
Total Outflows
9,590
Net Cashflows
NPV @12%
-9290
-1283
Willingness to pay for electricity
Economic Opportunity cost of Labor
Foreign Exchange Premium
Subsidy on Gas
Economic Opportunity cost of capital
Resource flow: Economic Points of View (millions Rs.)
2004 2005 2006
3300 3300
0
300
3300 3300 300
300
8000
1290
375
225
120
720
375
225
120
720
2580
2580
3.00 Rs/Kwh
80% of financial wage bill
15%
30% of Financial Cost
10%
375
225
120
720
375
225
120
720
0
2580 2580 300
Year
CF*
Inflows
Sales
Land (Subsidy)
Liquidation value of land
Total Inflows
1.36
0.00
1.00
Outflows
Land
Long term investment
Machinery
Equipment
Gas**
Coal
Labor Wages
Total Outflows
2001
2003
2004 2005 2006
4500
4500
4500 4500
4500
4500
300
4500 4500 300
0
0
1.00
300
1.15
1.15
1.50
1.15
0.80
9200
1484
Net Cashflows
NPV @10%
*CF = Conversion Factors
2002
0.00
560.63 560.6 560.6 560.6
258.75 258.8 258.8 258.8
96
96
96
96
10,984
915
915
915 915
-10984
566
3585
3585
0
3585 3585 300
**CF for gas = [(1.3)*(1.15)]/1 = 1.5
5
Three Postulates Underlying the Economic
Evaluation Methodology
•
•
•
•
These postulates in turn are based on a number of
fundamental concepts of welfare economics.
The competitive, demand price for an incremental
unit of a good or service measures its economic
value to the demander and hence its economic
benefit.
The competitive, supply price for an incremental
unit of a good or service measures its economic
resource cost.
Costs and benefits are added up without regard to
who the gainers and losers are.
6
What is the implication of these postulates for the
economic analysis of a project?
First Postulate
• The competitive demand price or the consumer’s willingness to pay for each
additional unit of consumption measures the economic benefit or the
economic price of each incremental unit.
• The demand curve reflects indifference on part of the consumer between
having a particular unit of a good at that price and spending the money on
other goods and services.
Economic Value of Local Calls for
Rural Customers
Tariff /Coping
Cost (US$/minute)
(MWTP)
P0 = 0.280
A
Consumer Surplus
(P1AC)
C
P1 = 0.120
Payment
for
services
Demand
Q0
Q1
Data Traffic (minutes/ year)
Economic value = Q0ACQ1 = Willingness to Pay
7
What is the implication of these postulates for the
economic analysis of a project? (Cont’d)
Second Postulate
•
The competitive supply price of each
incremental unit of a good measures the
economic cost of the resources (inputs) that
goes into the production of that unit.
•
The supply (marginal cost) curve represents
the minimum prices that suppliers are
willing to accept for successive units of a
good or service that they supply.
•
In a competitive market these minimum
prices represent the marginal opportunity
cost of these goods.
•
Suppliers will be indifferent between selling
incremental units of the good at their supply
prices or using the factors to produce other
goods and services.
Installation (Marginal Cost) of one
more terminal and demand for rural
telephone calls
Cost
MC
D2
D1
O
Q0
Q1 Q2
Number of rural telephone calls
8
What is the implication of these postulates for the
economic analysis of a project? (Cont’d)
Third Postulate
• Costs and benefits are added up without regard to who the
gainers and losers are.
• Should the project be valued differently depending on whom
are the beneficiaries and the losers? – Not by the economic
analysis
• This methodology measures the net economic benefit of the
project by subtracting the total resource costs used to produce
the project’s output from the total benefits of the output.
• It adds up the currency values of the net economic benefits
regardless of who are the beneficiaries or losers of the project.
• This approach attempts to separate the social aspects of project
appraisal from the economic efficiency aspects.
9
Analyzing Economic Costs and Benefits in an
Existing Market (in the absence of a new project)
Economic Costs and Benefits in an Existing Market
(a) Total Economic Benefit
(b) Total Economic Cost
Price in Rand/Unit
Price in Rand/Unit
P
Consumer
surplus
Producer
surplus
Pmax
max
Supply
Pm
C
Pm
Demand
0
Qm
C
E
0
Units of Output
Qm
Units of Output
(c) Total Economic Benefits and Costs
Price in Rand/Unit
Pmax
Pm
Supply
C
Demand
E
0
Qm
Units of Output
10
Illustration of Basic Postulates and Cost/Benefit Accounting Framework
Calculation of Net Economic Benefit Using
Postulate 3: A Dollar is a Dollar
Price
S
P
m
0
A = Consumers’ Surplus
B = Producers’ Surplus
C = Gross Economic Costs
A
s
o
=P =P
d
o
B
C
0
D
Quantity per year
Q0 m
Net Economic Benefit
= Total Economic Benefit
- Total Economic Cost
=
-
(A + B + C)
(C)
Net Economic Benefit
= Consumers’ Surplus
+ Producers’ Surplus
(A + B)
=
+
Consumers’ Surplus
= Total Economic Benefits
- Total Revenues
=
-
A
Producers’ Surplus
B
(A)
(A + B + C)
(B)
(B + C)
= Total Revenues
- Total Economic Cost
=
-
(B + C)
(C)
11
Analyzing Economic Costs and Benefits in an
Existing Market (in the absence of a new project)
• The analysis above indicates that the gross economic benefits
from the consumption of the output from this industry is
greater than the financial revenues received by the suppliers
due to the consumer surplus enjoyed by the consumers of the
output.
• It also indicates that the economic cost of producing the output
is less than the financial revenues received by the suppliers
yielding a producer surplus to the owners of the supply
facilities.
• The implication of these two facts is that the financial price of
a unit may be different from its economic price even in the
absence of distortions.
12
Estimation of Economic Prices
•
In order to estimate the true economic value of a good or
service, one needs to know:
Tradable, Non-Tradable or Rationed
• Is the good non-tradable (domestic)?
• Is the good or service now being rationed?
• Is the good internationally tradable?
• The difference is whether the price of the good is
determined by the forces of demand and supply in the
domestic market or given to the country by international
markets.
13
Defining a Price of Internationally Non-Traded
(Domestic) Good or Service
• Goods and services whose domestic production satisfies all the domestic
demand for these items and whose domestic prices are not affected by their
world prices are referred to as non-traded goods.
Price
Domestic Supply
S
Em * PCIF * (1+Tm) + Fm
Distorted World
Supply Price
Domestic price Pm
Em * PFOB* (1-tx) - Fx
Distorted World
Demand Price
D
Domestic Demand
Quantity
per year
14
Analyzing the Economic Benefits of an NonTraded Output Produced by a Project
Economic Benefits of a New Project in an Undistorted Market
S0
D0
Rand/Unit
S0+P
P0m
B
P1m
A
0
Q 1s
Financial Price = Q1s ACQ1d
C
Q0
Q1d
Units
Economic Value = Q1s ABQ 0 + Q 0 BCQ1d
Pe = W sPs + W d Pd
P0m + P1m
whe re, P =
2
s
P0m + P1m
P =
2
d
15
Analyzing the Economic Cost of an Input Demanded by a Project
Economic Cost of an Input Demanded by a Project
in an Undistorted Market
Rand/Unit
D0+P
D0
S0
C
P1m
A
P 0m
B
0
Financial Cost  Q1d CAQ1s
Q1d
s
Q0 Q1
Units
Economic Cost  Q 0 BAQ1s  Q1d CBQ0
Pe  W s Ps  W d Pd
P0m  P1m
where, P 
2
s
P0m  P1m
P 
2
d
16
Small versus Large Changes in Prices
• Often the quantity produced by a single project or purchases as
inputs by a project, is relatively small compared to the size of
the market and hence there is little or no change in the market
price.
• In such a situation and given that we are operating in an
undistorted market, the gross financial receipts will be equal to
the gross economic benefits. The triangle ABC is very small.
• A difference arises only when the quantity produced by the
project or demanded by the project is sufficiently large to have
an impact on the prevailing market price in the sector.
17
Applying the Postulates to Determine Economic Evaluation
of Non-Tradable Goods and Services in Distorted Markets
• Distortions are defined as market imperfections.
• The most common types of these distortions are in the form of
government taxes and subsidies. Others include quantitative
restrictions, price controls, and monopolies.
• We need to take the type and level of distortions as given and not
changed by the project when estimating the economic costs and
benefits of projects.
• The task of the project analyst or economist is to select the projects
that increase the net wealth of country, given the current and
expected regime of distortions in the country.
18
Sales Taxes Levied on Output of Project
Economic Cost of an Input Demanded by a Project
--- when a tax is imposed on sales --Rand/Unit
C'
P1d
B'
P d0
S0
P1m
P
A
C
m
0
B
D0
Dn+P
+TAX
Dn
Q1d
0
Q0
Financial cost is P1d (Q1s-Q1d)
P e = W s Ps + W d P d
Q1s
+TAX
Units
Economic cost is Q1dC’B’BAQ1s
m
m
P
+
P
0
1
whe re, P s =
2
d
d
P
+
P
0
1
Pd =
2
19
Sales Taxes Levied on Output of Project
Economic Benefit of an Output Supplied by a Project
--- when a tax is imposed on sales ---
Rand/Unit
P d0
S0
B'
S0+P
A'
P1d
B
P 0m
C
P1m
A
D0
Dn
Q1s
0
Financial benefit is P1m (Q1d-Q1s)
e
s
s
d
P = W P +W P
d
Q0
Q1d
Units
Economic benefit is Q1sCBB’A’Q1d
Pd=Pm+Ts if unit
whe re, P = P0m *tax
(1 + K)
d
m
P =P (1+t) if ad valorem
P0m
P =
(1 + K)
d
20
Economic Benefits of a New Project
-- when a production subsidy is present --
Subsidies on Production
S0
Rand/Unit
Ss=S0+Subsi
D0
dy
Ss+P
B'
Ps0
A'
B
m
0
P
P1m
0
C
A
Q1s
Q0
Financial benefit is P1m (Q1d-Q1s)
Pe  W s Ps  W d Pd
Q1d
Units
Economic benefit is Q1sA’B’BCQ1d
where, P s  P0m * (1  K )
Or if subsidy is proportion of total cost,
Pm
P 
1 K
s
and
Pd  Pm
21
Environmental Externalities
A Project with Pollution in the Lake
SC = S0 + Externality Cost
Price
B'
S0 = MPC
S0+P
A'
P0m
P1m
B
A
C
D
0
Financial benefit is P1m (Q1d-Q1s)
0
Q1s
Q0
Q1d
Quantity
Economic benefit is Q1sA’B’BCQ1d
22
Calculating the Economic Value of Non-Tradable Goods
Economic Value = Wxs P s
+
Wxd P d
= weighted average of supply (Ps) and demand (Pd) price
Where: Ws + Wd = 1
If Rationing then,
Traded : Importable
Exportable
Non-Traded
Three classes of goods:
Ws = 0 and Wd = 1
Ws = 1 and Wd = 0
Ws = 0 and Wd = 1
Ws > 0 and Wd > 0
Ws
2/3
1/2
1/3
Wd
1/3
1/2
2/3
23
Calculating the Economic Value of Non-Tradable Goods
Weights expressed in terms of elasticities:

Supply Elasticity
Wxs =
Supply Elasticity - Demand Elasticity
Demand Elasticity
Wxd =
Wxs
Wxd
Ps =
=
- 
-
=
Supply Elasticity - Demand Elasticity

=
-
Supply Price
P d = Demand Price
- 
 = (defined positively)own price elasticity of supply
 = (defined negatively) own price elasticity of demand
24
Applying the Postulates to Determine Economic
Evaluation of Tradable Goods and services
• The framework for the estimation of economic prices was
presented for the case of non-tradable goods.
• They are also applicable to the valuation of tradable goods.
• These postulates are general in nature and are also applicable
to tradable goods.
• The methodology for the estimation of the economic prices of
internationally tradable goods and services when there are
distortions in their markets is also based on the three
postulates.
• These distortions may include customs duties on imported
inputs of a project or those imported items that the project
output will replace or substitute.
25
The Economic Opportunity Cost of Capital
• One of the practical ways to measure this parameter is to use
the economic opportunity cost of funds that are drawn from
the capital market.
• In a small, open and developing economy, there are three
alternative sources for these public funds.
• The first source comes from those resources that would have
been invested in other investment activities that have been
either displaced or postponed by our project’s extraction of
funds from the capital market.
• The second source is from individual savers whose resources
would have been spent on private consumption due to an
increase in domestic savings.
• The third source is additional foreign capital inflows.
26
Foreign Exchange Externality
• The foreign exchange externality is meant to capture any
indirect external welfare effects that result from a project's
incremental use or production of foreign exchange.
• The source of this externality lies in the divergence that exists
between the marginal value of a unit of foreign exchange and
the marginal cost of earning that unit.
• This divergence is ultimately due to import tariff, export taxes,
sales taxes, excise taxes and any other tax or quantitative
restrictions distortions in the markets underlying the demand
and supply of foreign exchange.
27
The Economic Opportunity Cost of Labor
• In the labor market there are a variety of factors that may
create a divergence between the market wage and the
economic cost of a worker at the project.
• This cost of employment, referred to as the supply price of
labor, reflects both the value of the market and non-market
activities undertaken by the worker prior to joining the work
force at the project and all other factors that govern the
desirability of working at the project.
• It will also take into account any tax differentials that the
worker may face as a result of moving to the project from
another employment or unemployment
28