1 Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Two

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Lecture Notes

ECON 437/837: ECONOMIC

COST-BENEFIT ANALYSIS

Lecture Two

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PRINCIPLES UNDERLYING THE ECONOMIC ANALYSIS OF

PROJECTS

Interface of Project with the Markets

Factor Markets → Project → Output Market

(Labor & Capital)

The role of microeconomics in project evaluation is to determine economic benefits or economic costs, which differ, more often than not, from financial benefits or financial Costs.

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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 $1,000

investment and NPV equals to $ -270. Then the project uses $1,000

of resources and only produces $730 of value.

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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, e.g. road usage, water.

2. financial costs may not be the true costs, e.g. 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.

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Commodity Specific Conversion Factors (CSCF)

• Financial prices are market prices, which incorporate

all the tariffs, taxes, and subsidies. These market

distortions can often be combined and expressed as

a proportional distortion D.

valueFinancial

valueEconomicD )1(

FactorConversionD )1(

Where the combined rate of the distortions D is expressed as a proportion of the financial price

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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.

Price Financial

Value Economic=CSCFi

• 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.

85.0=R22,239

794,18R=CSCF YarnCotton 7

Example of Financial and Economic Cashflows: the Case of Electricity Project

Table of Parameters for Economic Analysis

Economic Opportunity cost of capital 10%

Economic Opportunity cost of Labor 80% of financial wage billForeign Exchange Premium 15%Subsidy on Gas 30% of Financial Cost

Willingness to pay for electricity 3.00 Rs/Kwh

Resource flow: Economic Points of View (millions Rs.)

Year CF* 2001 2002 2003 2004 2005 2006

Inflows Sales 4500 4500 4500 4500 Land (Subsidy) 0.00 0 Liquidation value of land 1.00 300Total Inflows 0 4500 4500 4500 4500 300

OutflowsLand 1.00 300Long term investment Machinery 1.15 9200 Equipment 1.15 1484 0.00Gas** 1.50 560.63 560.6 560.6 560.6Coal 1.15 258.75 258.8 258.8 258.8Labor Wages 0.80 96 96 96 96

Total Outflows 10,984 915 915 915 915 0

Net Cashflows -10984 3585 3585 3585 3585 300NPV @10% 566*CF = Conversion Factors

Table of Parameters for Financial Analysis

Price of Electricity 2.20 Rs/Kwh Long term investmentProduction of Electricity 1,500Gwh/year Machinery 8,000

Equipment 1,290Gas 0.25 per Kwh Financial CostLand (Given as subsidy) 300 of Capital 12%Coal 0.15 Rs/Kwh

Cashflow: Financial Points of View (millions Rs.)Year 2001 2002 2003 2004 2005 2006Inflows Sales 3300 3300 3300 3300 Land (Subsidy) 300 Liquidation value of investment 0 Liquidation value of land 300Total Inflows 300 3300 3300 3300 3300 300

OutflowsLand 300Long term investment Machinery 8000 Equipment 1290Gas 375 375 375 375Coal 225 225 225 225Labor Wages 120 120 120 120

Total Outflows 9,590 720 720 720 720 0

Net Cashflows -9290 2580 2580 2580 2580 300NPV @12% -1283

**CF for gas = [(1.3)*(1.15)]/1 = 1.58

Three Postulates Underlying the Economic Evaluation Methodology

• These postulates are based on a number of fundamental concepts of welfare economics.

1) 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.

2) The competitive supply price for an incremental unit of a good or service measures its economic resource cost.

3) Costs and benefits are added up without regard to who the gainers and losers are.

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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.

Demand

A

Q0

P1 = 0.120 C

Data Traffic (minutes/ year)Q1

(MWTP) P0 = 0.280

Tariff /Coping Cost (US$/minute)

Economic Value of Local Calls for Rural Customers

Economic value = Q0ACQ1 = Willingness to Pay

Consumer Surplus (P1AC)

Payment for

services

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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.

• Suppliers will be indifferent between selling incremental units of the good at their supply prices and using the factors to produce other goods and services.

• 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.

Q0

MC

Number of rural telephone calls

Cost

Q1 Q2O

Installation (Marginal Cost) of one more terminal and demand for rural

telephone calls

D1

D2

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Third Postulate• Costs and benefits are added up without regard to who the gainers

and losers are.– Focus on economic efficiency

• 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.

• This approach attempts to separate the social aspects of project appraisal from the economic efficiency aspects.

The implication of these postulates for the economic analysis of a project (Cont’d)

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• Output from a project affects the market equilibrium. The changes in quantity demanded, quantity supplied and price translate into cost savings due to cuts in production of inefficient producers and an increase in consumption because of lowering of the market price.

Measuring Economic Benefits of a Project’s Output

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Economic Benefits of Project Output (No Distortions)

Value of Resources Saved

Value of Increased Consumption

Price

S0 + Project

S0

D0

P0m

P1m

A

C

G F E

B

D

Q s1

d1QQ0 QT

Quantity

Economic Value = Wx

sPs+WxdPd

If no output market distortions, then: Ps = Pd = Pm

Financial benefit is P1m (Q1

d-Q1s)

Economic benefit is Q1sGCQ0 + Q0CFQ1

d

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• A project requires inputs for production. Demand of inputs by the project deprives some consumers in the market because of an increase in the market price. The rise in the market price invites additional investment in input markets, depriving funds for other sectors. These costs together constitute project’s gross economic costs.

Measuring the Economic Costs of a Project’s Inputs

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Economic Costs of Project Input(No Distortions)

2

2 re, whe

P

CBQQQQ Cost Economic QQ Cost Financial

m1

m0d

m1

m0s

ddsse

0d1

s10

s1

d1

PPP

PPP

PWPW

BACA

Qd1 Qs

1

S0

Pm0

A BC

Units

Rand/Unit

Q0

D0

D0+P

0

Pm1

Value of postponed consumption

Value of additional resources

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Small versus Large Changes in Prices

• Often the quantity produced by a single project or purchased 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.

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Wxs =

Supply Elasticity

Supply Elasticity - Demand Elasticity - =

Wxd =

Demand Elasticity -

Supply Elasticity - Demand Elasticity - =

= (defined positively) own price elasticity of supply

= (defined negatively) own price elasticity of demand

Weights expressed in terms of elasticities:

Wxs

Wxd

-=

These are long-run elasticities of demand and supply.

They are an average elasticity representing for the adjustments made by the market.

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Calculating the Economic Value of Non-Tradable Goods

Economic Value = Wxs P s + Wx

d P d

= weighted average of supply (Ps) and demand (Pd) price

Where: Ws + Wd = 1

• If rationing then Ws = 0 and Wd = 1• Traded: Importable Ws = 1 and Wd = 0

Exportable Ws = 0 and Wd = 1• Non-traded Ws 0 and Wd 0

Three classes of goods: Ws Wd

2/3 1/3

1/2 1/2

1/3 2/3

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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.

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1. Sales Taxes Levied on Output of ProjectEconomic Benefit of an Output Supplied by a Project

--- when a tax is imposed on sales ---

C

B

B'

A

Dn

S 0

S 0+P A'

Rand/Unit

0 d1Q Q0

s1Q

D0

Pd1

Pd0

Pm0

Pm1

Units


d-Q1s) Economic benefit is Q1

sCBB’A’Q1d

K)+(1

P=P )K+1(*P=P re, whePW+PW=P

m0dm

0sddsse

Pd = Pm + T if unit tax

Pd = Pm(1+t) if ad valorem

Ws P0m + Wd P0

m(1+t)Economic Benefits



Example

Wx s =1/3, Wx

d=2/3 Pm=120, tx =0.15

Pe = 1/3(120) + 2/3(120)(1+0.15) = 132

Pe = 40 + 80(1.15) = 13221

2. Subsidies on Production

1

s

KP

Pm

Q0 Units

Pm0

Pm1 A

Rand/Unit

0

B

C

D0

S0

Ss+P

Ss=S0+Subsi

dy B'

A'

Ps0

d1Q s

1Q

Economic Benefits of a New Project -- when a production subsidy is present --



sA’B’Q0+ Q0BCQ1d

)1(* re, wheP m0

sddsse KPPPWPW

Or if subsidy is proportion of total cost,

and d mPP

Example

Wxs =1/3, Wx

d=2/3 Pm=120, K=0.40

Pe = 1/3(120/(1-0.40)) + 2/3(120) = 146



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3. Sales Taxes Levied on Input of Project

Units d1Q

Pm0

C B

C'

A

Dn

D0

+TAX

S0

Q0

B'

Rand/Unit

0

Dn+P

+TAX

Pm1

Pd1

Pd0

s1Q

Economic Cost of an Input Demanded by a Project --- when a tax is imposed on sales ---

Financial cost is P1d (Q1

s-Q1d) Economic cost is Q1

dC’B’ Q0 + Q0 BAQ1

s

Example

Wxs = 0.25, Wx

d = 0.75, P0 m = 90, t = 0.15

Pe = 0.25[90] + 0.75 [90(1+0.15)] = 100



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4. Production Input SubsidizedEconomic Cost of an Input Demanded by a Project

--- when an input subsidy is present ---Price

S

P

E

G

F J

B

D

Qd1

s

1QQ

Quantity

H

A

s1

m1P=

/ (1-k)Pm0P

s0 =

/ (1-k)

P

P=

d1

m1P=

Pm0

d0

D0+Project

S0

0

C

I

After Subsidy

0

D0

Economic Costs

Wxs + Wx

d P mx0

mx0P

(1-k)

Example

Wxs = 0.25, Wx

d = 0.75, Pm = 90, k = 0.40

Pe = 0.25[90/(1-0.4)] + 0.75(90) = 105

Financial Cost is P1m (Q1

d-Q1s) Economic Cost is Q1

dEFQ0 + Q0GHQ1

S

Value of Postponed Consumption

Value of Additional Resources

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D0

Q00

E

Dn+P

H

Pz

JG

Q2d

P0m

P0s=P0

m/(1-kz)

S0+subsidy

Dn

Q1sQ1

d Qz

BC

N

A

P1m

S0

P1s=P1

m/(1-kz)P0

d=P0m (1+tz)

P1d=P1

m (1+tz) ML

UR

5. Sales Tax and Production Subsidy on InputEconomic cost of a Project

-- When a production subsidy and a sales tax are present --

Financial Cost is P1m (Q1

d-Q1s) Economic Cost is Q1

dMGQ0 + Q0RLQ1s

Example

Wxs = 0.25, Wx

d = 0.75 P0m = 90, t = 0.15, k = 0.4

P1s = 90/(1-0.4) = 150 , P1

d = 90(1+0.15) =103 , Pe = 0.25(150) + 0.75(103) = 114



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Price

Q0 Quantity

Ps=Pm

D0+P

D0

Q1

Economic Value of Increase in Quantity Demanded of an Input in the Case of the Infinite Supply Elasticity

- Example of Electricity Supply by Thermal Generation -

• Project demand (Q1 – Q0) of a non-tradable input

• Ws = 1 and Wd = 0

• If no direct subsidy then Ps = Pm

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6. Environmental Externalities

S0 = MPC

D0

SC = S0 + Externality Cost Price

Quantity

S0+P

C

B A

A'

B'

0 Qd

1 Q0 Qs

1

Pm1

Pm0

A Project with Pollution in the Lake



sA’B’BCQ1d

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Relationship between Market Prices and Demandand Supply Prices under Various Types of Distortions

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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.

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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.

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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.

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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 economic cost of employment 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.

Valuation of Non-Market Goods/Services

• Revealed preference method: using the data obtained by observing the actual choices made by individuals in related markets.

• State preference method: refer to direct survey approach to estimating the value placed on non-market goods or services.

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Documents

1 Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Two