3
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 $1000
investment and NPV equals to $ -270. Then the project uses
1000 of resources and only produces 730 of value.
4
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 eg. road usage, water.
2. financial costs may not be the true costs eg. 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.
• 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
6
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
1.36
Table of Parameters for Financial Analysis
Price of Electricity 2.20 Rs/Kwh Long term investmentProduction of Electricity 1,500Gwh/year Machinery 8000
Equipment 1290Gas 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 = 1.5
7
Three Postulates Underlying the Economic Evaluation Methodology
• These postulates in turn are based on a number of fundamental concepts of welfare economics.
• 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.
• The competitive, supply price for an incremental unit of a good or service measures its economic resource cost.
• Costs and benefits are added up without regard to who the gainers and losers are.
8
What is 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
9
What is 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.
• 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.
• Suppliers will be indifferent between selling incremental units of the good at their supply prices or using the factors to produce other goods and services.
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
10
Third Postulate
• Costs and benefits are added up without regard to who the gainers and losers are.
• 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.
• It adds up the currency values of the net economic benefits regardless of who are the beneficiaries or losers of the project.
• This approach attempts to separate the social aspects of project appraisal from the economic efficiency aspects.
What is the implication of these postulates for the economic analysis of a project? (Cont’d)
11
Analyzing Economic Costs and Benefits in an Existing Market (in the absence of a new project)
Price in Rand/Unit Price in Rand/Unit
Units of Output Units of Output
Pmax Pmax
Pm
0 Qm
C Pm
Qm 0
C
Demand
Supply
E
(a) Total Economic Benefit (b) Total Economic Cost
Units of Output
Price in Rand/Unit
Pmax
Pm C
0 Qm
Demand
Supply
E
(c) Total Economic Benefits and Costs
Economic Costs and Benefits in an Existing Market
Consumer surplus
Producer surplus
12
Illustration of Basic Postulates and Cost/Benefit Accounting Framework
Calculation of Net Economic Benefit Using Postulate 3: A Dollar is a Dollar
Price
so
Net Economic Benefit = Total Economic Benefit - Total Economic Cost
= (A + B + C) - (C)
Net Economic Benefit = Consumers’ Surplus + Producers’ Surplus
(A + B) = (A) + (B)
Consumers’ Surplus = Total Economic Benefits - Total Revenues
A = (A + B + C) - (B + C)
Producers’ Surplus = Total Revenues - Total Economic Cost
B = (B + C) - (C)
m0
Quantity per year
B = Producers’ SurplusA = Consumers’ Surplus
C = Gross Economic Costs
A
C
B
Q0m
D
S
doPP == P
0
13
Analyzing Economic Costs and Benefits in an Existing Market (in the absence of a new project)
• The analysis above indicates that the gross economic benefits from the consumption of the output from this industry is greater than the financial revenues received by the suppliers due to the consumer surplus enjoyed by the consumers of the output.
• It also indicates that the economic cost of producing the output is less than the financial revenues received by the suppliers yielding a producer surplus to the owners of the supply facilities.
• 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.
14
Estimation of Economic Prices
• In order to estimate the true economic value of a good or
service, one needs to know:
Tradable, Non-Tradable or Rationed
• Is the good non-tradable (domestic)?
• Is the good or service now being rationed?
• Is the good internationally tradable?
• The difference is whether the price of the good is
determined by the forces of demand and supply in the
domestic market or given to the country by international
markets.
15
Defining a Price of Internationally Non-Traded (Domestic) Good or Service
• Goods and services whose domestic production satisfies all the domestic
demand for these items and whose domestic prices are not affected by their
world prices are referred to as non-traded goods.
Distorted World Supply Price
Price
Quantity per year
Domestic Supply
Domestic DemandD
S
Em * PFOB* (1-tx) - Fx
Pm
Em * PCIF * (1+Tm) + Fm
Distorted World Demand Price
Domestic price
16
Analyzing the Economic Benefits of an Non-Traded Output Produced by a Project
Units
S0+P
Pm0
Pm1 A
Rand/Unit
0 Q s1 Q0
B
C
D0 S0
Qd1
Economic Benefits of a New Project in an Undistorted Market
2
P+P=P
2
P+P=P re, whe
PW+PW=P
BCQQ+QABQ = Value Economic QACQ = Price Financial
m1
m0d
m1
m0s
ddsse
d100
s1
d1
s1
17
Analyzing the Economic Cost of an Input Demanded by a Project
Qd1 Qs
1
S0
Pm0
A
B
C
Units
Rand/Unit
Q0
D0
D0+P
0
Pm1
Economic Cost of an Input Demanded by a Project in an Undistorted Market
2
2 re, whe
P
CBQQQQ Cost Economic QQ Cost Financial
m1
m0d
m1
m0s
ddsse
0d1
s10
s1
d1
PPP
PPP
PWPW
BACA
18
Small versus Large Changes in Prices
• Often the quantity produced by a single project or purchases 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.
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.
20
Sales Taxes Levied on Output 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’BAQ1s
2
P+P=P
2
P+P=P re, whePW+PW=P
d1
d0d
m1
m0sddsse
21
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
Pd=Pm+T if unit tax
Pd=Pm(1+t) if ad valorem
22
Subsidies on Production
1
s
K
PP
m
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’BCQ1d
)1(* re, wheP m0
sddsse KPPPWPW
Or if subsidy is proportion of total cost, and d mPP
23
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
24
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 = 1Traded : Importable Ws = 1 and Wd = 0 Exportable Ws = 0 and Wd = 1Non-Traded Ws > 0 and Wd > 0
Three classes of goods: Ws Wd
2/3 1/3 1/2 1/2 1/3 2/3
25
Wxs =
Supply Elasticity
Supply Elasticity - Demand Elasticity - =
Wxd =
Demand Elasticity -
Supply Elasticity - Demand Elasticity - =
P s = Supply Price
P d = Demand Price
= (defined positively)own price elasticity of supply
= (defined negatively) own price elasticity of demand
Weights expressed in terms of elasticities:
Wxs
Wxd
-=
Calculating the Economic Value of Non-Tradable Goods
26
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.
27
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.
28
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.
29
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 cost of employment, referred to as the supply price of
labor, 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