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
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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)
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Common sources of market imperfection in developing countries:
i.
Rationing
ii.
Prescription of minimum wage rate
iii.
Foreign exchange regulation
Externalities
ƒ External benefit or cost created by the project
ƒ Not usually included in the financial cost benefit analysis of
the project
ƒ 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:
ƒ Taxes are monetary costs
ƒ 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
ƒ Parts of benefit saved is deemed more valuable than the part
of benefits consumed
ƒ In SCBA higher valuation is placed on savings and a lower
valuation is put on consumption
Concern for redistribution
ƒ A taka of benefit going to an economically poor section is
considered more valuable than a taka of benefit going to an
affluent section
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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
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Shadow Pricing
Choice of Numéraire
ƒ 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
ƒ 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
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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
S`
D
E
P
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
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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
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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
= ∑ ∆Yi MPS i
Where, ∆Yi = change in income of group i due to the project
MPSi = marginal propensity to save of group 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 =  
 ci 
where, 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 income
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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
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