0 Updated: 06/03/2007 Lecture Notes ECON 622: ECONOMIC COST-BENEFIT ANALYSIS Lecture Two.

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Updated: 06/03/2007

Lecture Notes

ECON 622: ECONOMIC COST-BENEFIT ANALYSIS

Lecture Two

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PRINCIPLES UNDERLYING THE ECONOMIC ANALYSIS OF

PROJECTS

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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 $1000

investment and NPV equals to $ -270. Then the project uses

1000 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 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.

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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

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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

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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.

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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

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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

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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)

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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

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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

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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.

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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.

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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

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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

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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

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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.

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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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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

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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

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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

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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

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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 = 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

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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

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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 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