Transcript Topic 6: Economic Appraisal of Projects

Dr. M. Fouzul Kabir Khan
Professor of Economics and Finance
North South University
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Analyzing economic costs and benefits in
an existing market
Evaluation of costs and benefits in distorted
markets
Direct estimation of demand curve
Extrapolation and econometric estimation
(a) Total Economic Benefit
(b) Total Economic Cost
Price in Rand/Unit
Price in Rand/Unit
Pmax
Pmax
Consumer
surplus
Supply
Pm
C
Pm
Demand
0
Qm
E
0
Units of Output
(c) Total Economic Benefits and Costs
Price in Rand/Unit
Pmax
Pm
Supply
C
Demand
E
0
C
Qm
Units of Output
Qm
Units of Output
Producer
surplus
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The gross economic benefits from the consumption of
the output from this industry are greater than the
financial revenues received by the suppliers due to the
consumer surplus enjoyed by the consumers of the
output.
Economic cost of producing the output is less than the
financial revenues received by the suppliers due to the
producer surplus enjoyed by the suppliers.
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.

Valuing Project outputs
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Elastic demand, or a small project

Use market price

Quantity supplied by the project *market price
Perfectly inelastic supply


Will depend on the nature of the market in which the
output is traded.
Use average of before and after project prices, area under
the demand curve in the range of change in project
output.
How to find price after the project?
Analyzing the Economic Benefits of an Output
Produced by a Project
Analyzing the Economic Benefits of an Output
Produced by a Project
Analyzing the Economic Benefits of an
Output Produced by a Project
Economic Benefits of a New Project in an Undistorted Market:
Upward sloping supply (a large project)
Analyzing the Economic Benefit of an Output (subject
to tax) Supplied by a Large Project
•
If the quantity demanded by the project is relatively
small compared to the size of the market then there will
only be a very small change in the market price.
•
In such a situation and given that we are operating in an
undistorted market, the gross financial cost to the
project will be equal to the gross economic cost.
•
A difference only arises when the change in the quantity
demanded by the project is sufficiently large to have a
large impact on the prevailing market price.
Economic Cost of an Input Demanded by a Project in an
Undistorted Market: Elastic supply, large market or a small project


If the quantity demanded by the project is large
compared to the size of the market then there will only
be a change in the market price.
Government purchasing land
◦ Purchase price, P2*(q-q1)
◦ Economic costs

P1  P2
* (q  q ' )
2
Land taken through eminent domain
◦ Economic costs
Pres  P2
* (q  q ' )
2
Analyzing the Economic Cost of an Input
Demanded by a Project
Economic Cost of an Input Demanded by a Project in an
Undistorted Market: Inelastic supply
Analyzing the Economic Cost of an Input
Demanded by a Project
Economic Cost of an Input Demanded by a Project in an
Undistorted Market: Upward sloping supply curve and a large Project

Large project subject to purely revenue generating input
tax

General principles:
◦ When a project reduces the quantity of input available
for other people, use the willingness to pay (as
indicated by the demand curve) as value
◦ When a project increases the quantity of input that the
market must produce, use marginal cost for the value
of the added input
◦ Tax is treated as transfer
Analyzing the Economic Cost of an Input
(subject to tax) Demanded by a Project

A project uses large quantity of cements to build a
bridge. Cements are subject to a Tk. 1/bag tax and
100 million bags will be used to build the bridge.
As a result of the bridge, the price of cement
including the tax, will rise to from Tk. 2 to Tk. 2.30
per bag and private consumers are expected to
decrease their consumption by 20 million bags.
What costs should be attached to this input?
Analyzing the Economic Cost of an Input (subject
to taxes related to externalities) Demanded by a
Project
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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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If market or government failures distort the relevant
product market, then project benefits are measured by
the changes in social surplus resulting from the project
plus net revenues generated by the project
Monopoly
◦ As in the competitive case, the social surplus
generated by the output produced and sold in the
monopolist is represented graphically by the area
between the demand schedule and the marginal cost
curve that is to the left of the MR and MC curves
◦ Social surplus above the price is received by the
consumers and that below the price is captured by the
producer.
◦ Monopolist is a part of the society; therefore benefits
accruing to them count.
◦ Breaking the monopoly will increase social surplus;
 Deadweight loss would disappear.
 Consumers will capture a part of the
monopolists producers surplus, viewed as
transfer.
Valuation of Benefits in Distorted
Markets

Natural Monopoly

1.
2.
3.
4.
Four policies
Allow monopoly, deadweight loss abc, monopoly profits=Pmafg.
Regulate monopoly, set PR = AC, eliminates monopoly profits,
transferring social surplus to persons using the road, expands
output, reduces deadweight loss from area abc to area dec,
society’s benefit adeb.
Require road authority to set Pc , eliminates deadweight loss,
price is less than AC, revenue no longer cover costs, subsidy
would be required.
Free access, marginal costs exceed willingness to pay,
deadweight loss chQo, no toll revenue, entire construction and
operation costs have to be subsidized.
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Information Asymmetry
Externalities
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Negative Externality
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Positive Externality
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Too low price, too much output, deadweight loss
Impose tax t
Social accounting ledger
Too high price, too little output
Provide subsidy v
Social accounting ledger
Public goods

Little or none will be produced, willingness to pay, optimal level of
output of public goods
Valuation of benefits in Distorted
Markets
Valuation of benefits in Distorted Markets
Valuation of benefits in Distorted
Markets
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Purchase at below opportunity costs
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e.g. witnesses, commuting costs, lost labor
Hiring unemployed labor
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Five alternative measures of social cost of hiring unemployed labor
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Zero opportunity costs, other productive work, value of
leisure, value of time: Pe, Pc,Pd, Pd, Pr. Opportunity cost should
be non-zero
Budgetary expenditure, workers were willing to work for less,
subtract producers surplus, transfer to the workers
Area cdLdLt
½(Pm+Pr)(L’)
½(Pm)(L’), assumes Pr to be zero
Purchases from a monopolist
Measuring Costs in Inefficient Markets

The general rule
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In factor markets in which supply is taxed, direct expenditure
outlays overestimate opportunity cost
In factor markets in which supply is subsidized, direct
expenditure outlays underestimate opportunity cost
In factor markets exhibiting positive externalities of supply,
expenditures overestimate opportunity costs
In factor markets exhibiting negative externalities of supply,
expenditures underestimate opportunity costs
Opportunity cost equals direct expenditure in the factor
market minus (plus) gains (losses) in social surplus
Occurring in the factor market

Trade effects of outputs
◦ Extra export
◦ Less imports
◦ A combination of the two

Trade effects of inputs
◦ More imports
◦ Less exports
◦ A combination of the two

Economic benefit of exported/importable output

Economic cost of imported/exportable input

In project analysis we estimate change in social
surplus to value impact of the program/project
◦ Need to know the shapes of the supply and demand
curves
 There are well functioning competitive
markets, know only one point on the
demand and supply curves, represented by
the equilibrium
 Goods that are rarely traded in marketshealth and safety, pollutions, access to
scenic areas
 Commodities that are traded in imperfect
markets, monopoly, asymmetric
information, and externalities
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Estimating benefits and cost based on demonstration or pilot
programs.
Alternative evaluation designs:
– Classical experimental design with or without baseline data
– Simple before and after comparison
– Non-experimental comparison with or without baseline data
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Limited applications:
– Employment and training programs, people oriented service
– A new dam, on a small scale, pilot basis cannot be done
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Advantages:
– A bad idea can be abandoned
– Needed adjustment in the program may be made
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Disadvantages:
– May not readily translate into a large-scale program
– Uncertainty concerning external validity
 Three possibilities
 Knowing one point on the demand curve and its
slope or elasticity.
 Extrapolating from a few points, know a few
points on the demand curve that can be used to
predict another point of relevance to policy
evaluation.
 Econometric estimation with many observations,
have a sufficient number different observations
of prices and quantities.
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Current refuse disposal is 2.6lbs per person per day
and disposed off in containers of 20lbs
Currently there is no charge on refuse collection
Marginal social cost (collection + landfill costs) =
0.6/lb
In new Delhi for each Rupee increase in price of
refuse collection reduces wastes by 0.4 lb/p/d
Assume a linear demand curve
Evaluate impact of imposition of a fee of 0.05/lb, i.e.
Tk. 1 for each container of 20lbs, MPC is less than
MSC
Using a Slope Estimate

Linear demand curve
q   0  1 p
Slope or elasticity estimates from previous
research
Assuming α0 = 2.60, α1= - 0.4
 Estimating social surplus gain from charging
for refuse disposal

◦ A graphical illustration
Social Surplus Gain from Refuse Fee
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We have an estimate of price elasticity of demand
from previous research
◦
◦
◦
◦
•
εd = α1 p/q
α1 = εd q/p
εd=-0.12
p = 0.81, and q = 2.62, α1 = -0.40
Construction of a linear demand curve to measure
changes in social surplus requires either a direct
estimate of the slope itself or an estimate of the
price elasticity of demand and the price and
quantity at which the elasticity was estimated.


Effect of a fare increase on bus ridership
◦ If the past fare increase of Tk. 1 resulted in 1000 fewer
riders , then it may be reasonable to assume that a further
increase of Tk.1 will have the same effect
◦ Assumed functional relationship between the outcome and
the policy variable
 Linear functional forms can produce very different
predictions than constant-elasticity functional forms
 Further we extrapolate from past experience, the more
sensitive are our predictions to assumptions about
functional form
Econometric estimation with many observations
◦ If many observations of quantities demanded at different
prices are available, then it may be possible to use
econometric techniques to estimate demand schedule
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Government supply many goods that are also provided by the
private sector, e.g. education
Using price and quantity of an analogous private sector good
to estimate the demand curve for a publicly provided good
The market price of a comparable good in the private sector
is an appropriate shadow price for a publicly provided good,
if it equals the average amount that users of the publicly
provided good will be willing to pay
– Private and public goods must be comparable in quality of
service and other important characteristics
– Limitations:
• Using private sector revenues would underestimate benefits,
because it omits consumer surplus
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Using the market analogy method to value time saved
– Bridge, highway improvement saves time
– Wage rate
– Limitations of wage rate
• Benefits, should be added to wages
• People work during travel
• Truck drivers work, to be counted,
wage + benefit
• Taxes, After tax wage rate plus benefit
• Pleasure travel
• Dirty, dangerous jobs, unemployed

Using Airbags in car would increase
probability of survival in a accident from p to
p + w.

Additional cost of an airbag is Tk.1,000

W=1/1000

Calculate value of life.
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One type of construction job has a 1/1000
greater chance of a fatal injury in a year than
another type of construction job.
Suppose riskier job pays a salary that is Tk.
2000 higher than the safer job
Calculate value of life.

Using the market analogy method to value life saved
◦ Foregone earnings method
 Value of life saved equals the present value of future
earnings
◦ Consumer purchase studies
(p+w)V(Life) –Tk. 1000 = pV(life)
(p+w)V(Life) - pV(life) = Tk. 1000
wV(life) = Tk. 1000
V(life) = Tk. 1000 /w, w =1/10,000
V(life) = Tk. 1000 /(1/10,000)
= Tk. 10,000,000
◦ Labor market studies
(1/1000) V(life) = Tk. 2000
V(life) = Tk. 2 million

Intermediate good method
◦ If the output from a project is to be used as an input into the
production of some other good, then the effects on profits of
the other, downstream industry can be included as a benefit,
e.g. irrigation, education and training, value added
 Excludes consumer surplus
 Double counting, demand curve for water, benefits to farmer

Asset valuation method
◦ Increase or decrease in the property value following
implementation of a project, e.g. location of jail, park
 Ex post CBA
 Assumes other factors remaining the same
 Not applicable in case of mobile assets
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Used in valuing recreational sites
Steps in travel cost method
– Visitors from different origins bear different travel costs
depending on their proximity to the site
– The resulting differences in total cost, and the differences in
the rates of visit that they induce provide a basis for
estimating demand curve for the site
– Select a random sample of households within the market area
of the site
– Survey the households to determine their number of visits to
the site over some period of time, all of their costs involved in
visiting the site, the cost of visiting substitute sites, their
incomes, and their other characteristics
– Specify a functional form for the demand schedule and
estimate it using the survey data
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Shadow prices
Project analysis in developing countries
LMST accounting price method in practice
Intermediate goods and asset valuation
method
Travel cost method
Social discount rate
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When a market does not exist or market failure
leads to a divergence between market price and
marginal social cost, analysts try to obtain
estimates of what market price would be if the
relevant good were traded in a perfect market.
Such an estimate is called a shadow price
Estimates of shadow prices when markets are
missing
– Examples: value of a unit of time, statistical life, or the
(negative) value of a particular type of crime
Shadow Prices
Shadow Prices
Shadow Prices
Plug-Ins for Value of Travel Time Saved
Shadow Prices
Plug-Ins for Value of Recreational Activities (in 1999 U.S. dollars)
Shadow Prices
Plug-Ins for Value of Environmental Impact (in 1999 U.S. dollars)


Project Analysis in developing countries have much in
common with Project Analysis in industrialized countries
The main distinguishing characteristic of Project Analysis in
developing countries is the much grater emphasis on
adjusting the market prices of project output and inputs so
that they more accurately reflect their value to society
◦ Markets are more distorted in developing countries
 Segmented labor market
 Overvalued exchange rate
 Tariffs, taxes, and import controls
 Formal and informal credit markets
◦ Use shadow prices/accounting prices instead of market
prices

Developed by UNIDO, I.M.D Little and J.A. Mirrlees,
synthesized by Lynn Squire and Herman G. van der
Tak

The LMST methodology
◦ Use world prices as shadow price for all project inputs and
outputs that are classified as tradable
◦ World prices are less distorted than domestic prices
 Imported input valued at import price, CIF
 Exported output valued at export price, FOB

Examples
◦ Steel plant
◦ Agricultural crop
•
Shadow pricing involves multiplying each market
price by an accounting price ratio
– APR for good i = accounting/shadow price of good i
/market price of good i
– Shadow price of good i = APR of good i *market price of
good i
– Small country assumption
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Shadow price of an imported input or an output
that is an import substitute
Shadow price of an export
Shadow price of a non-tradable good (electricity)
•
CIF price * Exchange rate = World Price in
domestic currency
– Use shadow exchange rate, if there is a big
difference between official and market exchange
rates
•
Accounting prices
•
Shadow price= Market Price*APR
– CIF price: APR = 1
– Tariff : APR = 0
– Transport cost: APR = 0.5
– Distribution cost: APR = 0.8
– Weighted APR: 0.85
Accounting Price of an Imported Good
Item
Dollar
Price
Market
Price(Tk)
APR
Accounting
Price
CIF Price
40
2800
1.00
2800
Tariff
-
350
0.00
-
Transport
-
280
0.50
140
Distribution -
175
0.80
140
3605
0.85
3080
Total
FOB Price
• Export tax is a transfer between foreign
purchaser (no standing) and the government:
APR= 1
• Transport for export: APR= 0.5
• Factory gate price: APR=1
• Shadow price
= 5180*1+70*0.5+1750*1
=Tk. 6965
•
Accounting Price for Export
FOB Price
Dollar
Price
100
Export tax
25
Transport
1
Item
Market
Price(Tk)
7000
APR Accounting
Price
-
1750
1.0
1750
0.5
35
5180
1.0
5180
70
Factory
Gate
Transport(d)
-
120
0.5
60
Distribution(d)
-
300
0.8
240
74
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LMST involves determining the equivalent
value of non-tradables in world prices
Breaking down the cost of inputs into traded,
non-traded and labor components
Multiply market price by applicable
accounting price ratio
– CIF prices: APR =1
– Domestic transfer (tariffs and taxes): APR = 0
– Labor: APR = 0.6
– Standard conversion factor: 0.80
Accounting Price for Electricity Valued or
Marginal Cost of Supply (in thousands of pesos)

Semi-input-output analysis

Consumption conversion factors
Weighted average of accounting price ratios for a
nationally representative market basket of goods

Standard conversion factors
SCF = (M+X)/[(M+ Tm –Sm)+(X-Tx+Sx)]
Where M= Total value of imports(CIF)
X = Total value of exports(FOB)
Tm = Total tariff on imports
Tx = Total taxes on exports
Sm = Total subsidies on imports
Sx = Total subsidies on exports
Average value of SCF for different countries 0.8
(ranges between 0.59-0.96)
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Constant marginal costs up to capacity level, up to Q1 and then
completely inelastic
Whether the fixed supply is binding or not
If not binding (demand with the project within the elastic range), no
change in market price. Would not affect the current consumers of
electricity
◦ Would require additional input to produce additional electricity,
use shadow cost method for non-tradables
If binding, (demand with the project is in the inelastic range), market
price will increase. Current consumers lose surplus and producers
gain surplus
Measured in market prices, the cost of electricity would equal
[(P1+P2)/2](Q1-Q2)
To convert into shadow price equivalent, multiply the cost by the
consumption conversion factor( weighted average of accounting
price ratios for a nationally representative market basket of goods).
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
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
Location of the project
Source of labor
Accounting price ratio of type j labor = Shadow
price of type j labor/ the market wage for type j
labor
Shadow price of foreign workers
◦ SWf = [h + (1-h)(CCF)](PW)
◦ Where PW is the project wage, h is the fraction of PW sent
or taken home, and 1-h is the fraction spent domestically

Rural market wage
◦ RMW = 0.5($50) + 0.25($10) + 0.25($.15) = Tk. 31.25
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How much current consumption society is willing to give up now
in order to obtain a given increase in future Consumption?
It is generally accepted that society’s choices, including the
choice of weights be based on individuals’ choices
Three unresolved issues
– Whether market interest rates can be used to represent how individuals
weigh future consumption relative to present consumption?
– Whether to include unborn future generation in addition to individuals
alive today?
– Whether society attaches the same value to a unit of investment as to a
unit of consumption
•
Different assumptions will lead to choice of different discount
rate


Generally a low discount rate favors projects with
highest total benefits, irrespective of when they
occur, e.g. project C
Increasing the discount rate applies smaller
weights to benefits or (costs) that occur further in
the future and, therefore, weakens the case for
projects with benefit that are back-end loaded
(such as project C), strengthens the case for
projects with benefit that are front-end loaded
(such as project B).
NPV for Three Alternative Projects
Year
Project A
Project B
Project C
0
-80,000
-80,000
-80,000
1
25,000
80,000
0
2
25,000
10,000
0
3
25,000
10,000
0
4
25,000
10,000
0
5
25,000
10,000
140,000
Total benefits
45,000
40,000
60,000
NPV (i=2%)
37,838
35,762
46,802
NPV (i=10%)
14,770
21,544
6,929
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As individuals, we prefer to consume immediate benefits to ones
occurring in the future (marginal rate of time preference)
We also face an opportunity cost of forgone interest when we
spend money today rather than invest them for future use
(marginal rate of return on private investment)
In a perfectly competitive market:
rate of return on private investment = the market interest rates =
marginal rate of time preference (MRTP)
The rate at which an individual makes marginal trade-offs is
called an individuals MRTP
Therefore, we may use the market interest rate as the social
discount rate
Equality of MRTP and Market Interest Rate
• Six
potential discounting methods
– Social discount rate equal to marginal rate of return on
private investment, rz
– Social discount rate equal to marginal rate of time
preference, pz
– Social discount rate equal to weighted average of pz, rz
and i , where i is the government’s real long-term
borrowing rate
– Social discount rate is the shadow price of capital
– A discount rate that declines over the time horizon of
the project
– A discount rate SG, based on the growth in real per capita
consumption
 Using
the marginal rate of return on private investment
◦ The government takes resources out of the private sector
◦ Society must receive a higher rate of return compared to the
return in the private sector
 Criticism
◦ Too high
 Return on private sector investment incorporates a risk premium
◦ Government project might be financed by taxes, displaces
consumption rather than investment
◦ Project may be financed by low cost foreign loans
◦ Private sector return may be high because of monopoly or
negative externalities
◦ Government investment sometimes raises the private return on
capital
 Using
the marginal social rate of time preference, pz
◦ Numerical values of pz
 Real after-tax return on savings, around 2 percent for the US economy
 Criticisms
◦ Individuals have different MRTP
◦ How to aggregate such individual MRTP
◦ Market interest rate reflects MRTP of individuals currently alive
 Using
the weighted social opportunity cost of capital
WSOC= arz + bi + (1-a-b)pz
◦ Numerical Value, 3 percent for the US economy
Social discount rate should be obtained by weighting rz
and pz by the relative size of the relative contributions
that investment and consumption would make toward
funding the project
s = arz + (1-a)pz,
where a = ΔI/(ΔI+ ΔC) and (1-a) = ΔC/(ΔI+ ΔC)
 Savings are not very responsive to changes in the
interest rate, ΔC is close to zero
 The value of the parameter a is close to one
 The marginal rate of return on private investment rz is a
good approximation of true social discount rate

Criticisms
of WSOC
 Criticisms applicable to use of rz and pz applies
 Different discount rates for different projects based on
source of financing
Use
the shadow price of capital
 Strong theoretical appeal
 Discounting be done in four steps
 Costs and benefits in each period are divided into those that
directly affect consumption and those affect investment
 Flows into and out of investment are multiplied by the shadow
price of capital θ, to convert them into consumption equivalents
 Changes in consumption are added to changes in consumption
equivalents
 Discounting the resultant flow by pz
•
Shadow price of capital

(rz   )(1  f )
p z  rz f   (1  f )
Where rz is the net return on capital after
depreciation, δ is the depreciation rate of capital, f
is the fraction of gross return that is reinvested,
and pz is the marginal social rate of time preference
– Numerical values for the θ,SPC, 1.5-2.5 for the US
economy
– Applying SPC in practice
•
Criticism of calculation and use of the SPC


Using time-declining discount rates
Conclusion, social discounting in imperfect markets
◦ If all costs and benefits are measured as increments to
consumption, use MSRTP, pz, Boardman et. Al. suggests a value
of 2 percent, sensitivity 0-4 percent
◦ If all costs and benefits are measured as increments to private
sector investment, use MRROI, rz, Boardman et. Al. suggests a
value of 8 percent, sensitivity 6-10 percent
◦ If all costs and benefits are measured as increments to both
consumption and private sector investment, use SPOC, θ, to
increments in investment and then discount at MSRTP,
Boardman et. Al. suggests for SPOC, a value of 1.65 percent,
sensitivity 1.3-2.7 percent; and ΔI = 15 percent and, ΔC= 85
percent, in the absence of information

Many government agencies do not discount at all

Shadow price of capital is rarely used

Governments do not use time-varying discount rates

Constant positive rate that varies from country to country
◦ US, 7-10 percent
◦ Canada, 10 percent, sensitivity 5-15 percent
◦ 0-3 percent for Health and Environment Projects

ADB, EIRR of 10-12 percent
Illustration of the Travel Cost Method
Zone
Travel
Time
(hours)
A
0.5
2
20
15
525
5,250
150
B
1.0
30
30
13
390
3,900
130
C
2.0
90
65
6
75
1,500
120
D
3.0
140
80
3
15
150
30
E
3.5
150
90
1
0
0
10
10,800
440
Total
Travel
Distanc
e
(km)
Actual
total
cost
per
person
(Tk.)
Average Consumer Consumers
number
s
Surplus per
of Visits
Surplus
Zone (Tk.
per
per Person thousands)
Person
Trips per
Zone
(thousand
s)
Travel Cost Method