Economic, Social and Environmental Cost Benefit Analysis

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Economic and Social Cost Benefit Analysis

Dr. Tarun Das, Professor (Public Policy), IILM, New Delhi-110003.

EMAIL: [email protected]/[email protected]

1. Introduction

After examining the technical feasibility of a project, it needs to be examined whether the

project is financially viable, economically sustainable and socially desirable.

Accordingly, there are three basic cost-benefit appraisal techniques, depending on thepurpose of the project, the methods for project financing, policies for recovering of costs

and fixing of charges from the users. These methods stand as follow:

(a) Financial cost-benefit analysis

(b) Economic cost-benefit analysis and

(c) Social cost benefit analysis.

The traditional financial cost-benefit analysis deals with actual financial transactions andmakes orthodox commercial analysis on the basis of market prices of products and all

factors of production. It does not deal with the questions of distributional equity and doesnot make an analysis of the impact of externalities. The financial analysis generally

estimates the cost/ benefit ratio (CBR), net present value of benefits (NPVoB) and the

Internal Rate of Return (IRR).

In the economic cost-benefit analysis, instead of market prices, the appraisal is based on

the economic costs or the resource costs or opportunity costs of the both factors ofproduction and the inputs. This is done on the basis of the following two adjustments in

the financial cost-benefit analysis:

(i) All costs are netted out of all taxes, duties and subsidies.

(ii) The scarce and surplus factors are shadow priced. One attaches shadow prices to

labour, energy and foreign exchange cost to take care of their either scarcity values orslack values. In general, shadow prices for scarce items (i.e. items with excess

demand) will have shadow prices higher than their market prices, whereas items with

excess supply (for example unskilled labour) will have shadow prices lower than theirmarket prices.

Social cost benefit analysis goes further beyond the financial and economic cost-

benefit analysis, and deals with not only efficiency pricing but also takes care ofdistributional equity and impact of externalities on the project.

The two most prominent methodologies, which address these issues in a systematic way,are the UNIDO (1972) and Little Mirrelees (1968, 1974) book on projects appraisal.

Continual discussions and debates on these two approaches have led to a vast literature

on refinements and synthesis of techniques, and more sophistication in comparison withthe conventional commercial profitability analysis.

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2. Project Appraisal Techniques

Given limited public resources and competing sectors needing public funds, it isnecessary to make a comprehensive analysis of social costs and social benefits of a

project and to bring its coherence to the list of investment projects. What is needed for

that is a technique that would rank projects in order of their economic desirability, so thatthey could be adopted in rank order until the investment budget is exhausted.

Previously, development economists had argued the merits of different criteria fordeciding on project investment - the degree of capital intensity, the rate of reinvestment,

the internal rate of return, the cost/benefit ratio, the size of the externalities and so on.

The integration of these various investment criteria within a single procedure of appraisal

of net present value was the work of Little and Mirrlees.A major issue of project appraisal is to measure the true cost of transferring a marginal

unit of rural labour to urban employment, rather than assuming (as Lewis did) that the

transfer is costless. At the same time, the valuation of a projects non-labour inputs and

outputs also pose difficult problems. They are due to the interventions by thegovernments that affect price formation in both rural and urban areas. For example,

procurement of Foodgrains at minimum support prices by the government pushes upmarket prices, while supply of subsidized Foodgrains through ration shops puts

downward pressure on market prices.

Thus determination of market price is a complex issue. In any case, they are deviationsfrom the market-clearing prices in a perfectly competitive market. These deviations are

referred to as price distortions, but the idea of a price distortion makes sense only relative

to some standard of undistorted prices. Little and Mirrlees proposed world prices astheir sheet anchor, but there are skepticisms among the economists, as there is no single

world price. However, the use of world prices as a norm markes a significant shift in

economic thinking about development, even though in practice the social cost-benefitappraisal techniques are scarcely more successful that the financial cost benefit analysis

or economic appraisal of projects.

The social cost benefit appraisal procedure for projects is very complex, even with short

cuts. Moreover, no procedure can preclude opportunities for manipulating the numbers to

give the result that political masters would like to have on non-economic considerations.

Moreover, there is a more fundamental problem. The SCBA technique is an attempt touse shadow prices to select investments, that is, to invest as if free market prices ruled,

when in fact they do not.

It is well known that perfect competitions is a utopia and does not exist in reality. The

real world is neither competitive nor perfect. Investments chosen on the basis of

economic costs or resource cost would not necessarily be financially viable unless theexisting prices are determined by the economic costs. That imply that the survival of the

projects would depend either on the governments continuing ability to give them

subsidies, a condition that becomes more difficult as the politico-economic turbulence of

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the 1970s unfolded. The alternative and the recommended option for the government is

to dismantle the interventions that prevent projects from being profitable.

To give an example, in the middle of 1980s, the Planning Commission built up a

transport-planning model on the basis of economic costs where labour labour, foreign

exchange and energy costs were shadow-priced. Financial wage costs were reduced by 20percent, while energy costs were enhanced by 20 percent and foreign exchange costs

were enhanced by 25 percent (i.e. shadow price of labour was taken as 0.8, and shadow

price of energy as 1.2 and shadow price of foreign exchange as 1.25). On the basis ofeconomic cost, road transport cost was observed to be lower than the rail transport cost

for short distance, while rail transport had comparative advantage for long distance. On

this basis, modal shares for rail and road were projected for future, and required capacity

expansions were proposed. It was estimated that rail should have a share of 75 percent intotal goods and passenger traffic.

However, rail passenger fares and freight rates for goods traffic were not determined on

the basis of economic costs. As a result, over the years, actual modal shares becamecompletely irrational and non-optimal, 75 percent by roads and 25 percent by rail,

resulting in loss of public resources.

3. Identificaton of Benefits and Costs

In social cost benefit analysis, the most important and the most difficult task is to identifyand measure all social costs and benefits associated with the projects. These costs and

benefits arise due to externalities of the project. They relate to local resources, eco-

system and overall environment. While the technical feasibility and the financial viabilityexcercises are well developed and there are conventional methods to conduct those

studies, economic and social cost-benefit analysis depend on the purpose of the studies.

Let me discuss these problems in relation to two project reports submitted to the Ministry

of Rural Development, which I had a chance to look at.

4. Evaluation of Poverty Alleviation Programs

Growth with social justice and alleviation of poverty have been primary objectives of

Indian planning since its inception in 1951. Several anti-poverty programs have been inoperation for decades focussing the poor as the target groups. These include programs for

the welfare of weaker sections, women and children, and a number of special

employment programs for self- and wage employment in rural and urban areas. Theongoing economic reforms since 1991 have also a human face and attached high priority

to the development of social sectors.

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The government has relied mainly on two approaches for poverty alleviation: the first

based on the anticipation that economic growth will have a trickle down effect on the

levels of living of all groups in society; and the second that direct anti-poverty programsare also required. More recently, government shifted public expenditure away from

investment in infrastructure and industry towards social sectors, and improved targeting

of subsidies through changes in the public distribution system.

Anti-poverty programs have been strengthened over the years to generate more

employment, create productive assets, impart technical and entrepreneurial skills andraise the income level of the poor. But most evaluations - whether done by the

government or others - agree that these programs have not been very effective in reducing

poverty, as these suffer from ill-defined multiple objectives, limited targeting towards the

poor, under-funding and often complex administration, high administrative costs andleakage, lack of proper accountability and adequate monitoring.

For example, a recent study of the Public Distribution System (PDS) suggested that as

little as 25 per cent of the foodgrains actually reach the poorest 40 per cent of thepopulation and that administrative costs far outweigh the income gains to the poor. In

general, it costs the government between 2 and 7 rupees (with the highest value reportedfor the PDS) to provide one rupee to the poor. One of the better-targeted programs is the

Integrated Child Development Services (ICDS). Similarly, public works have been

relatively more successful at targeting the poor and have improved significantly the living

standards of a large number of poor at a relatively low cost.

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DR. TARUN DAS

Professor and Area Head (Economics)

Institute for Integrated Learning in Management3 Lodhi Institutional Area, New Delhi-11000

Tel: 2588-4540, Mobile: 9818024569

E-mail: [email protected]/[email protected]

Brief Bio-data

Dr. Tarun Das is a development economist with 35 years experience. He is presently

working as Professor (Public Policy) in the Institute for Integrated Learning in

Management, New Delhi. Earlier, he worked as an Economic Adviser in the Ministryof Finance and the Planning Commission, Chief Economist, Ministry of Steel, and

Chief (Eco. Division) in the Bureau of Industrial Costs and Prices.

He is a Gold Medallist in Economics from Calcutta University, and holds a Ph.D.degree as Commonwealth Scholar from the East Anglia University, England.

He was a Member of the high-level government delegations to the IMF, World Bank,

ESCAP, UCTAD, WTO, and UN Commission on Sustainable Development.

He also worked as a Consultant to the World Bank, Asian Development Bank,

Economic Commission for Africa, UNDP, United Nations Institute for Training andResearch (UNITAR), UN-ESCAP and International Labour Organisation (ILO).

He is a widely traveled person and possesses diversity in skills in teaching, training,

research, policy planning and modeling. He is an acknowledged expert in the field ofeconomic reforms, transport modeling, project appraisal, poverty and inequality,

foreign investment policies and management of external debt; and has published a

number of books and papers on these subjects

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Economic, Social and Environmental Cost Benefit Analysis