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1
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.
5
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
14
• 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
15
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
16
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.
17
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
19
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
Financial benefit is P1m (Q1
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
Value of Increased Consumption
Value of Resources Saved
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 --
Financial benefit is P1m (Q1
d-Q1s) Economic benefit is Q1
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
Value of Resources Saved
Value of Increased Consumption
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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
Value of postponed consumption
Value of additional resources
23
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
24
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
Value of additional resources
Value of postponed consumption
25
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
Financial benefit is P1m (Q1
d-Q1s) Economic benefit is Q1
sA’B’BCQ1d
27
Relationship between Market Prices and Demandand Supply Prices under Various Types of Distortions
28
29
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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