Chapter 14 Social Cost Benefit Analysis

CHAPTER 14SOCIAL COST BENEFIT ANALYSIS

OUTLINE

Rationale for SCBA UNIDO approach Net benefit in terms of economic (efficiency) prices Savings impact and its value Income distribution impact Adjustment for merit and demerit goods Little-Mirrlees approach Shadow prices SCBA by financial institutions Public sector investment decisions in India

Rationale for SCBA In SCBA the focus is on the social costs and benefits of the project. These often tend to differ from the monetary costs and benefits of the project. The principal sources of discrepancy are : Market imperfections Externalities Taxes and subsidies Concern for savings Concern for redistribution Merit wants

UNIDO Approach The UNIDO method of project appraisal involves five stages:Calculation of the financial profitability of the project measured at market prices.Obtaining the net benefit of the project measured in terms of economic (efficiency) prices.Adjustment for the impact of the project on savings and investmentAdjustment for the impact of the project on income distributionAdjustment for the impact of the project on merit goods and demerit goods whose social values differ from their economic values.Each stage of appraisal measures the desirability of the project from a different angle.

Net Benefits in Terms of Economic (Efficiency) PricesShadow Pricing : Basic Issues Choice of numeraire Concept of tradability Concept of shadow prices Taxes Consumer willingness to pay Tradable inputs and outputs Non-tradable inputs and outputs Externalities Labour inputs Capital inputs Foreign exchangeShadow Pricing of Specific Resources

Illustration Presently, a ferry service, operated privately, is being used to cross a river. The ferry operator charges Rs.3 per person. It costs him Rs.2 per person. 50,000 persons use the ferry service. (This means that the number of persons crossing the river by ferry service throughout the year is 50,000) The government is considering construction of a bridge over the river. It is estimated that after the bridge is constructed 2,50,000 persons will cross the river on the bridge. The bridge is expected to cost Rs 3 million initially and its annual maintenance cost would be Rs 10,000. It has an indefinitely long life. Once the bridge is constructed the ferry operator is expected to close down the ferry service and sell the ferry boats for Rs.100,00.

Required : Define the social costs and benefits of constructing the bridge, assuming that the monetary figures given in the problem represent economic values.

Solution : The social costs and benefits of bridge construction may be defined as follows: Costs These consists of the following:1. Construction cost : Rs.3,000,000 (This is a one-shot cost)2. Maintenance cost : Rs. 10,000 (This is an annual cost)Benefits These consist of the following :1. Value of ferries released : Rs 100,000 ( This is one-shot benefit)2. Savings in the cost of ferry operation: Rs 100,000 (This is an annual benefit) 3. Increase in consumer satisfaction: This is equal to willingness to pay of 200,000 additional persons who are expected to use the bridge. Since the first additional person is willing to pay almost Rs 3 (the charge of the ferry operator) and the late person is willing to pay almost nothing (there is no toll for using the bridge) the average willingness to pay of additional users, assuming that the demand schedule is linear, is Rs. 1.50. So the willingness to pay of 200,000 additional persons is is 200,000 x Rs 1.50 = 300,000.

Measurement of the Impact on DistributionStages three and four of the UNIDO method are concerned with measuring the value of a project in terms of its contribution to savings and income redistribution. To facilitate such assessments, we must first measure the income gained or lost by individual groups within the society For income distribution analysis, the society may be divided into various groups. The UNIDO approach seeks to identify income gains and losses by the following:

Project Other private business Government Workers Consumers External sector [The gain or loss to an individual group within the society as a result of the project is equal to the difference between the shadow price and the market price of each input or output in the case of physical resources or the difference between the price paid and the value received in the case of financial transactions.

Savings Impact and its ValueMost of the developing countries face scarcity of capital. Hence, the governments of these countries are concerned about the impact of a project on savings and its value thereof. Stage three of the UNIDO method, concerned with this, seeks to answer the following questions: Given the income distribution impact of the project what would be its effect on savings? What is the value of such savings to the society?

Impact on SavingsThe savings impact of a project is equal to: i MPSiWhere i = change in income of group i as a result of the project MPSi = marginal propensity to save of group iExample As a result of a project the income gained /lost by four groups is : Group 1 = Rs. 100,000 Group 2 = Rs 500,000, Group 3 = -Rs.200,000 and Group 4 = -Rs 400,000. The marginal propensity to save of these four groups is as follows: MPS1 = 0.05, MPS2 = 0.10, MPS3 = 0.20, and MPS4 = 0.40The impact on savings of the project is: 100,000 x 0.05 + 500,000 x 0.10 200,000 x 0.20 400,000 x 0.40 = - Rs.1,45,000

Value of Savings r(1-a) r(1-a)(1+ar) r(1-a)(1+ar)n-1 (!+k) (1+k)2 (1+k)n r(1-a) (1+k) r(1-a) (1+ar) (k-ar) (1+k) Where I = social value of savings (investment)r = marginal productivity of capitala = reinvestment rate on additional income arising from investment k = social discount rateI = + +..+ +. = = 1-

Income Distribution ImpactMany governments regard redistribution of income in favour of economically weaker sections or economically backward regions as a socially desirable objective. Due to practical difficulties in pursuing the objective of redistribution entirely through the tax, subsidy, and transfer measures of the government, investment projects are also considered as investments for income redistribution and their contribution toward this goal is considered in their evaluation. This calls for suitably weighing the net gain or loss by each group, measured earlier, to reflect the relative value of income for different groups and summing them.

In general, the weight attached to an income is given by the formula: b n ciWhere wi = weight attached to income at ci level b = base level of income that has a weight of 1 n = elasticity of the marginal utility of incomewi

Adjustment for Merit and Demerit GoodsIn some cases, the analysis has to be extended beyond stage four to reflect the difference between the economic value and social value of resources. The difference exists in the case of merit goods and demerit goods. A merit good is one for which the social value exceeds the economic value. For example, a country may place a higher social value than economic value on production of oil because it reduces dependence on foreign supplies. The concept of merit goods can be extended to include a socially desirable outcome like creation of employment. In the absence of the project, the government perhaps would be willing to pay unemployment compensation or provide mere make-work jobs. In case of a demerit good, the social value of the good is less than its economic value. For example, a country may regard alcoholic products as having a social value less than the economic value.

Little-Mirrlees ApproachThere is considerable similarity between the UNIDO approach and the L-M approach. Both the approaches call for: 1. Calculating accounting (shadow) prices particularly for foreign exchange savings and unskilled labour. 2. Considering the factor of equity 3. Use of DCF analysisDespite considerable similarities there are certain differences between the two approaches: 1. The UNIDO approach measures costs and benefits in terms of domestic rupees whereas the L-M approach measures costs and benefits in terms of international prices, also referred to as border prices. 2. The UNIDO approach measures costs and benefits in terms of consumption whereas the L-M approach measures costs and benefits in terms of uncommitted social income. 3. The stage-by-stage analysis recommended by the UNIDO approach focuses on efficiency, savings, and redistribution considerations in different stages. The L-M approach, however, tends to view these considerations together.

Shadow Prices The outputs and inputs of a project are classified into the following categories: traded goods and services, non-traded goods and services, and labour. The shadow price of a traded good is simply its border price The shadow (or accounting) price of a non-traded item is defined in terms of marginal social cost and marginal social benefit.

Use of Conversion FactorsIdeally, the accounting price of a non-traded item is defined in terms of marginal social cost and marginal social benefit. In practice, the calculation of marginal social cost and marginal social benefit is often a difficult task. As a practical expedient, L-M suggest that the monetary cost of a non-traded item be broken down into tradable,labour, and residual components. The tradable and residual components may be converted into social cost by applying suitable social conversion factors; the labour components social cost can be obtained by using social wage rate

Shadow Wage RateThe shadow wage rate is an important but difficult-to-determine element in social cost benefit analysis. It is a function of several factors: (i) the marginal productivity of labour, (ii) the cost associated with urbanisation (cost of transport,urban overheads, etc.), and (iii) the cost of having an additional amount committed to consumption when the consumption of the worker increases as a result of the higher income he enjoys in urban employment.L-M suggest the following formula for calculating the shadow wage rate: SWR = c 1/s (c-m)Where SWR = shadow wage rate c = additional resources devoted to consumption 1/s = value of a unit of committed resource c = consumption of the wage earner m = marginal product of the wage earner

Accounting Rate of ReturnThe accounting rate of return (interest) is the rate used for discounting social profits. In determining the accounting rate of return the following considerations should be borne in mind: The future social profit for all projects must be discounted in the same way The accounting rate(s) of interest should be such that all mutually compatible projects with positive present social value can be undertaken. The accounting rate of interest should maintain some kind of balance between investment and investible resources: too low an accounting rate of interest would lead to over-investment with inflationary effects and too high an accounting rate of interest would leave savings under-utilised and result in excessive unemployment.

SCBA by Financial InstitutionsThe all India term-lending financial institutions, IDBI, IFCI, and ICICI (IDBI and ICICI have now become universal banks) appraise projects primarily from the financial point of view. However, they also scrutinise projects from the larger social point of view. ICICI was perhaps the first financial institution to introduce a system of economic analysis as distinct from financial profitability analysis. IFCI adopted a system of economic appraisal in 1979. Finally, IDBI also introduced a system for economic appraisal of projects financed by them. Though there are some minor variations, the three institutions follow essentially a similar approach which is a simplified version of the L-M approach. We shall describe the appraisal procedure followed by IDBI. IDBI, in its economic appraisal of industrial projects, considers three aspects: Economic rate of return Effective rate of protection Domestic resource cost

Economic Rate of ReturnThe method followed by IDBI to calculate the economic rate of return may be described as a Partial Little-Mirrlees method because while international prices are used for valuation of tradable inputs and outputs, L-M method is not followed in its entirety. The significant elements of IDBIs method are described below: International prices are regarded as the relevant economic prices and, hence, it is necessary to substitute market prices with international prices for all non-labour inputs and outputsFor tradable items, where international prices are directly available, CIF prices are used for inputs and FOB prices are used for outputsFor tradable items where international prices are not directly available and for non-tradable items (like electricity, transportation, etc.), social conversion factors are used to convert actual rupee cost into social cost.

Effective Rate of ProtectionTariffs, import restrictions, and subsidies are used to encourage domestic industries and protect them against international competition. The extent to which a project is sheltered is measured by the Effective Rate of Protection (ERP) . It is calculated as follows: Value added at domestic prices - Value added at world prices Value added at world pricesThis ratio is multiplied by 100 to express the ERP in percentage terms.The data required for calculating the ERP may be arranged as follows: At domestic prices At world prices A. Selling price B. Input cost: Traded Non-traded C. Value added

Domestic Resources CostDomestic resources cost (DRC) reflects the domestic cost incurred per unit of foreign exchange saved or earned. Financial institutions use the following formula to calculate DRC A + B + C DRC = x Exchange rate P (Q + R + S + T)Where A = annual charge on domestic capital calculated at the rate of 10 percent. B = annual depreciation on domestic capital assets (other than land) calculated at the rate of 8 percent C = annual cost of non-traded inputs P = sales realisation at international prices Q = annual charge on imported capital assets at the rate of 10 percent R = annual depreciation on imported capital assets at the rate of 8 percent S = annual cost of imported inputs T = annual cost of domestically procured, but tradable inputs

Public Sector Investment Decisions in IndiaVery broadly the principal steps in the public investment decision making process in India are as follows:The Planning Commission formulates the five-year plan indicating the broad strategy of planning, the role of each sector, the physical targets to be achieved by each sector, and the financial outlays to be made available for the development of each sector.The administrative ministries develop sectoral plans. It is in these plans that the projects of the public sector enterprises are identified. The identification of a project provides the green signal for the preparation of its feasibility report.The concerned public sector enterprise prepares the feasibility report and forwards it to its administrative ministry.The administrative ministry carries out a preliminary scrutiny of the feasibility report and sends copies of the same to the various appraising agencies, namely, the Planning Commission, the Department of Economic Affairs and the Plan Finance Division of the Finance Ministry, and the Bureau of Public Enterprises for their comments.

The PAD of the Planning Commission carries out a detailed appraisal. The objective of its appraisal is not only to suggest whether to accept or reject the project but also to suggest how it may be re-formulated to enhance its technical, financial, commercial, and economic viability.The Investment Planning Committee of the Planning Commission discusses the appraisal note of the PAD and recommends to the PIB the view of the Planning Commission on whether the project should be accepted, rejected, deferred, reformulated, or redesigned.The PIB considers the (a) appraisal note of the PAD along with the view of the planning Commission, (b) the comments of the BPE, (c) the comments of the plan finance division of the ministry of finance, and (d) the note of the administrative ministry. If the PIB clears the project, it sends it to the cabinet for its approvalThe cabinet generally accepts the recommendation of the PIB and approves its implementation.

SUMMARY

In SCBA the focus is on social costs and benefits of a project. These often tend to differ from the costs incurred in monetary terms and benefits earned in monetary terms by the project. The principal reasons for discrepancy are: (i) market imperfections, (ii) externalities, (iii) taxes, (iv) concern for savings, (v) concern for redistribution, and (iv) merit and demerit goods Towards the end of the sixties and early seventies two principal approaches for SCBA emerged : UNIDO approach and Little- Mirrlees approach. The UNIDO method of project appraisal involves five stages: (i) calculation of the financial profitability of the project measured at market prices; (ii) obtaining the net benefit of the project measured in terms of economic (efficiency) prices; (iii) adjustment for the impact of the project on savings and investment; (iv) adjustment for the impact of the project on income redistribution; and (v) adjustment for the impact of the project on merit and demerit goods. As per the L-M approach, the outputs and inputs of a project are classified into the following categories: (i) traded goods and services, (ii) non-traded goods and services, and (iii) labour.

The shadow price of a traded good is simply its border price. If a good is exported its shadow price is its FOB price and if a good is imported its shadow price is its CIF price. The shadow prices for non-traded items are defined in terms of marginal social cost and marginal social benefit. The L-M approach suggests the following formula for calculating the shadow wage rate (SWR) SWR = c 1/s (c-m) While the all-India term-lending institutions IDBI, IFCI, and ICICI- approach project proposals primarily from the financial point of view, they also evaluate them from the larger social point of view. Though there are some minor variations, the three institutions follow essentially a similar approach which is a simplified version of the L-M approach. IDBI, the apex term-lending financial institutions, considers three aspects in its economic appraisal of industrial projects: economic rate of return, effective rate of protection, and domestic resource cost The economic rate of return is simply the internal rate of return of the stream of social costs and benefits. The effective rate of protection is calculated as follows: Value added at domestic prices - Value added at world prices Value added at world prices.

Till the middle of the sixties the mechanism for appraisal and selection of public sector projects was rather primitive. To improve the quality of project planning and strengthen the public investment decision making process several steps were taken: creation of the Bureau of Public Enterprises; establishment of the Project Appraisal Division (PAD) in the Planning Commission; and institution of the Public Investment Board (PIB).