- to describe and quantify the social advantages and disadvantages of a policy in terms of a common monetary unit

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Beatrice Palmer
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1 Cost-Benefit Analysis - to describe and quantify the social advantages and disadvantages of a policy in terms of a common monetary unit Evaluation on the basis of Benefits Benefit refers to the addition to the flow of national output occurring from a project. Real and Nominal Benefits Direct and Indirect Benefits Tangible and Intangible Benefits Evaluation on the basis of Costs Project Cost Associated costs Real and Nominal Costs Primary or Direct Costs Indirect or Secondary Costs 1

2 Social Cost Benefit Analysis (SCBA) - Economic analysis - A methodology developed for evaluating investment projects from the point of view of the society (or economy) as a whole. - Used primarily for public investment SCBA aids in evaluating individual projects o Spells out broad national economic objectives o Allocation of resources to various sectors SCBA is concerned with tactical decision making within the framework of broad strategic choices defined by planning at the macro level. Rationale for SCBA Focuses on the social cost and benefits of the project Principle sources of discrepancy: o Market Imperfection o Externalities o Taxes and Subsidies o Concern for Savings o Concern for redistribution o Merit Wants Market Imperfection Market prices reflect social values only under condition of perfect competition (which are rarely realized by developing countries) 2

3 Common sources of market imperfection in developing countries: i. Rationing ii. Prescription of minimum wage rate iii. Foreign exchange regulation Externalities External benefit or cost created by the project Not usually included in the financial cost benefit analysis of the project In SCBA all external costs and benefits, irrespective to whom they accrue and whether they are paid for or not, are relevant Taxes and Subsidies From private point of view: Taxes are monetary costs Subsidies are definite monetary gains From social point of view taxes and subsidies are generally regarded as transfer payments and hence considered irrelevant. Concern for Savings Parts of benefit saved is deemed more valuable than the part of benefits consumed In SCBA higher valuation is placed on savings and a lower valuation is put on consumption Concern for redistribution A taka of benefit going to an economically poor section is considered more valuable than a taka of benefit going to an affluent section 3

4 Merit Wants Goals and preferences not expressed in the market place, but believed by policy makers to be in the larger interest, may be referred to as merit wants. UNIDO Approach Two principle approach for SCBA: - UNIDO Approach - Little-Mirrlees Approach UNIDO method involves five stages: 1. Calculation of financial profitability measured at market prices 2. Obtaining the net benefit of the project measured in terms of economic (efficiency) prices 3. Adjustment for the impact of the project on savings and investment 4. Adjustment for the impact of the project on income distribution 5. Adjustment for the impact of the project on merit goods and demerit goods Net benefit in terms of Economic (Efficiency) prices: - Also referred to as shadow prices - Market prices represent shadow prices only under conditions of perfect markets - So, shadow prices need to be developed and economic benefit need to be measured in terms of these prices 4

5 Shadow Pricing Choice of Numéraire the unit of account in which the value of inputs or outputs is expressed o What unit of currency (domestic or foreign)? o Current values or constant values? o With reference to which point present or future? o In terms of consumption or investment? o With reference to which group? UNIDO Numéraire: net present consumption in the hands of people at the base level of consumption in the private sector in terms of constant price in domestic accounting unit. Concept of Tradability For tradable goods, the international price is a measure of its opportunity cost to the country o Substitute import for domestic production and vice versa o Substitute export for domestic consumption and vice versa Hence, the international price, also referred to as the border price, represent the real value of the good in terms of economic efficiency. Tax Sources of Shadow Prices UNIDO approach suggests three sources of shadow pricing: i. Increase or decrease the total consumption in the economy ii. Decrease or increase production in the economy iii. Increase or decrease export or import 5

6 Shadow pricing measurement Sources of Shadow pricing Increase/Decrease of consumption Increase/Decrease of production Increase/Decrease of export/import Basis of shadow pricing Consumer willingness to pay Cost of production Foreign exchange value Consumer Willingness to pay: Price D S` P E S D` O Q Quantity DD = Demand Schedule SS = Supply Schedule OQ = Quantity Bought OP = Price per unit Total willingness Price Paid Consumer surplus = ODEQ = OPEQ = DEP 6

7 Externalities Characteristics: It is not deliberately created by the project sponsor but is an incidental outcome of legitimate economic activity It is beyond the control of the persons who are affected by it, for better or for worse It is not traded in the market Examples of beneficial external effects: An oil company drilling in its own fields may generate useful information about oil potential in the neighboring fields The approach roads built by a company may improve the transport system in that area The training program of a firm may upgrade the skills of its workers thereby enhancing their earning power. Can be measured by indirect means: What the neighboring oil fields would have spent to obtain the information The value of better transport may be estimated in terms of increased activities and benefits derived from these. Benefit from the training program may be estimated in terms of the increased earning power of workers Examples of harmful external effects: A factory may cause environmental pollution and people living adjacent to it may be exposed to health hazards Airport in a certain area may raise noise level considerably in the neighborhood A highway may cut a farmer s holding in two adversely affecting his physical output. Can be measured by indirect means: Cost of pollution in terms of loss of earnings as a result of damage to health and cost of time spent for coping Cost of noise from difference in rent Effect of highway on consumer willingness to pay for output 7

8 Measurement of the Impact on distribution Groups UNIDO approach seeks to identify income gains and losses by the followings: Project Other private business Government Workers Consumers External Sector Measures of Gain or loss - of individual group - difference between the shadow price and the market price of each input or output Savings Impact and its value UNIDO method seeks to answer the following questions: Given the income distribution impact of the project what would be its effects on savings? What is the value of such savings to the society? Impact on savings Y MPS i Where, = i Yi = change in income of group i due to the project MPS = marginal propensity to save of group i i Income Distribution Impact - can be determined directly by the planner - for different income groups relative weights can be assigned - using elasticity of marginal utility of income n b wi = c i where, w i = weight attached to income at c i level b = base level of income that has a weight of 1 n = elasticity of the marginal utility of income 8

9 Adjustment for Merit and Demerit Goods Adjusting for the difference between social value and economic value: 1. Estimate the economic value 2. Calculate the adjustment factor as the difference between the ratio of social value to economic value and unity 3. Multiply the economic value by the adjustment factor to obtain the adjustment 4. Add the adjustment to the net present value of the project 9

Notes Revised Case study application 1. The economic problem

Notes Revised Case study application 1. The economic problem (a) Factors of production Understand the nature of + identify egs of land, labour, capital and enterprise. (b) Scarcity, choice and opportunity cost Appreciate the basic economic problems of scarcity,