CHAPTER 14
SOCIAL 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.
*hese often tend to differ from the monetary costs and benefits of the
project. *he principal sources of discrepancy are +
•
Market imperfections
•
Externalities
•
*axes and subsidies
• Concern for savings
• Concern for redistribution
• Μerit wants
UNIDO Approach
The UNIDO method of project appraisal involves five stages:
/.
Calculation of the financial profitability of the project measured at
market prices.
0. Obtaining the net benefit of the project measured in terms of economic
(efficiency) prices.
1. Adjustment for the impact of the project on savings and investment
2. Adjustment for the impact of the project on income distribution
3. Adjustment for the impact of the project on merit goods and
goods whose social values differ from their economic values.
demerit
Each stage of appraisal measures the desirability of the project from a
different angle.
Net Benefits in Terms of Economic
(Efficiency) Prices
Shadow Pricing : Basic Issues
• Choice of numeraire
• Concept of tradability
• Concept of shadow prices
• *axes
• Consumer willingness to pay
Shadow Pricing of Specific Resources
• *radable inputs and outputs
• Non-tradable inputs and outputs
• Externalities
• Labour inputs
• Capital inputs
• 4oreign exchange
Illustration
Presently5 a ferry service5 operated privately5 is being used to cross a river. *he
ferry operator charges Rs.1 per person. It costs him Rs.0 per person. 365666
persons use the ferry service. (*his means that the number of persons crossing
the river by ferry service throughout the year is 365666)
*he government is considering construction of a bridge over the river. It is
estimated that after the bridge is constructed 05365666 persons will cross the
river on the bridge. *he bridge is expected to cost Rs 1 million initially and its
annual maintenance cost would be Rs /65666. 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./66566.
Re7uired + Define the social costs and benefits of constructing the
bridge5 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 Distribution
Stages 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. *o facilitate
such assessments5 we must first measure the income gained or lost by individual groups
within the society
4or income distribution analysis5 the society may be divided into various groups. *he
UNIDO approach seeks to identify income gains and losses by the following+
• Project
• Other private business
• Government
• Workers
• Consumers
• External sector
<
*he gain or loss to an individual group within the society as a result of the project is
e7ual 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 Value
Most of the developing countries face scarcity of capital. Hence5 the
governments of these countries are concerned about the impact of a
project on savings and its value thereof. Stage three of the UNIDO
method5 concerned with this5 seeks to answer the following 7uestions+
• 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 Savings
The savings impact of a project is equal to:
∑ ∆Υi MPSi
Where ∆Υi = change in income of group i as a result of the project
MPSi = marginal propensity to save of group i
Example 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 = 0.40
The 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(/-a)
I 9
r(/-a)(/@ar)
@
(/@k)0
r(/-a)(/@ar) n-/
(/@k)n
r(/-a)
(/@k)
9
r(/-a)
9
(/@ar)
(k-ar)
/(/@k)
Where I 9 social value of savings (investment)
r 9 marginal productivity of capital
a 9 reinvestment rate on additional income arising
from investment
k 9 social discount rate
Income Distribution Impact
Many 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 tax5 subsidy5 and transfer
measures of the government5 investment projects are also considered as
investments for income redistribution and their contribution toward this
goal is considered in their evaluation. *his calls for suitably weighing
the net gain or loss by each group5 measured earlier5 to reflect the
relative value of income for different groups and summing them.
In general5 the weight attached to an income is given by the
formula+
wi
b
n
ci
Where wi 9 weight attached to income at ci level
b 9 base level of income that has a weight of /
n 9 elasticity of the marginal utility of income
Adjustment for Merit and Demerit Goods
In some cases5 the analysis has to be extended beyond stage four to
reflect the difference between the economic value and social value
of resources. *he 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. 4or example5 a country may place a
higher social value than economic value on production of oil because
it reduces dependence on foreign supplies. *he concept of merit
goods can be extended to include a socially desirable outcome like
creation of employment. In the absence of the project5 the
government perhaps would be willing to pay unemployment
compensation or provide mere make-work jobs.
In case of a demerit good5 the social value of the good is less than
its economic value. 4or example5 a country may regard alcoholic
products as having a social value less than the economic value.
Little--irrlees Approach
*here is considerable similarity between the UNIDO approach and the L-M approach.
Both the approaches call for+
/. Calculating accounting (shadow) prices particularly for foreign
exchange savings and unskilled labour.
0. Considering the factor of e7uity
1. Use of DC4 analysis
Despite considerable similarities there are certain differences
approaches+
between the two
/. *he UNIDO approach measures costs and benefits in terms of domestic
rupees whereas the L-M approach measures costs and benefits in terms of
international prices5 also referred to as border prices.
0. *he 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.
1. *he stage-by-stage analysis recommended by the UNIDO approach focuses
on efficiency5 savings5 and redistribution considerations in different stages.
Shadow Prices
• *he outputs and inputs of a project are classified into the following
categories+ traded goods and services5 non-traded goods and services5
and labour.
• *he shadow price of a traded good is simply its border price
• *he shadow (or accounting) price of a non-traded item is defined in
terms of marginal social cost and marginal social benefit.
Use of Conversion Factors
Ideally5 the accounting price of a non-traded item is defined in terms of
marginal social cost and marginal social benefit. In practice5 the
calculation of marginal social cost and marginal social benefit is often a
difficult task. As a practical expedient5 L-M suggest that the monetary
cost of a non-traded item be broken down into tradable5labour5 and
residual components. *he tradable and residual components may be
converted into social cost by applying suitable social conversion factors;
the labour componentEs social cost can be obtained by using social wage
rate
Shadow Wage Rate
*he 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 labour5 (ii) the cost associated with urbanisation
(cost of transport5urban overheads5 etc.)5 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 9 c’ — //s (c-m)
Where SWR 9 shadow wage rate
c’ 9 additional resources devoted to consumption
//s 9 value of a unit of committed resource
c 9 consumption of the wage earner
m 9 marginal product of the wage earner
Accountin& Rate of Return
*he 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+
• *he future social profit for all projects must be discounted in
the same way
• *he accounting rate(s) of interest should be such that all
mutually compatible projects with positive present social value
can be undertaken.
• *he 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
SCBA by Financial Institutions
*he all India term-lending financial institutions5 IDBI5 I4CI5 and ICICI (IDBI
and ICICI have now become universal banks) appraise projects primarily from
the financial point of view. However5 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. I4CI adopted a system of economic appraisal in /FGF. 4inally5 IDBI
also introduced a system for economic appraisal of projects financed by them.
*hough there are some minor variations5 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.
IDBI5 in its economic appraisal of industrial projects5 considers three aspects+
• Economic rate of return
• Effective rate of protection
• Domestic resource cost
Economic Rate of Return
*he method followed by IDBI to calculate the economic rate of return may
be described as a HPartial Little-MirrleesE method because while
international prices are used for valuation of tradable inputs and outputs5 LM method is not followed in its entirety. *he significant elements of IDBIEs
method are described below+
/. International prices are regarded as the relevant economic prices
and5 hence5 it is necessary to substitute market prices with
international prices for all non-labour inputs and outputs
0. 4or tradable items5 where international prices are directly available5
CI4 prices are used for inputs and 4OB prices are used for outputs
1. 4or tradable items where international prices are not directly
available and for non-tradable items (like electricity5 transportation5
etc.)5 social conversion factors are used to convert actual rupee cost
into social cost.
Effective Rate of Protection
*ariffs5 import restrictions5 and subsidies are used to encourage domestic
industries and protect them against international competition. *he extent to
which a project is sheltered is measured by the Effective Rate of Protection
(ERP) . It is calculated as follows+
8alue added at domestic prices - 8alue added at world prices
8alue added at world prices
*his ratio is multiplied by /66 to express the ERP in percentage terms.
*he data re7uired for calculating the ERP may be arranged as follows+
At domestic prices
A. Selling price
B. Input cost+ *raded
Non-traded
C. 8alue added
At world prices
Domestic Resources Cost
Domestic resources cost (DRC) reflects the domestic cost incurred per unit of
foreign exchange saved or earned. 4inancial institutions use the following
formula to calculate DRC
A@B@C
DRC 9
x Exchange rate
P — (Q @ R @ S @ T)
Where A 9 annual charge on domestic capital calculated at the rate of
/6 percent.
B 9 annual depreciation on domestic capital assets (other than
land) calculated at the rate of 8 percent
C 9 annual cost of non-traded inputs
P 9 sales realisation at international prices
Q 9 annual charge on imported capital assets at the rate of /6
percent
R 9 annual depreciation on imported capital assets at the rate of 8
percent
S 9 annual cost of imported inputs
T 9 annual cost of domestically procured5 but tradable inputs
Public Sector Investment Decisions in India
8ery broadly the principal steps in the public investment decision making process
in India are as follows+
/. *he Planning Commission formulates the five-year plan indicating the
broad strategy of planning5 the role of each sector5 the physical targets to be
achieved by each sector5 and the financial outlays to be made available for
the development of each sector.
0.
*he administrative ministries develop sectoral plans. It is in these plans that
the projects of the public sector enterprises are identified. *he identification
of a project provides the green signal for the preparation of its feasibility
report.
1.
*he concerned public sector enterprise prepares the feasibility report and
forwards it to its administrative ministry.
2.
*he administrative ministry carries out a preliminary scrutiny of the
feasibility report and sends copies of the same to the various appraising
agencies5 namely5 the Planning Commission5 the Department of Economic
Affairs and the Plan 4inance Division of the 4inance Ministry5 and the
Bureau of Public Enterprises for their comments.
3. *he PAD of the Planning Commission carries out a detailed appraisal.
*he 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 technical5 financial5 commercial5 and economic viability.
J. *he 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
accepted5 rejected5 deferred5 reformulated5 or redesigned.
G. *he PIB considers the (a) appraisal note of the PAD along with the
view of the planning Commission5 (b) the comments of the BPE5 (c)
the comments of the plan finance division of the ministry of finance5
and (d) the note of the administrative ministry. If the PIB clears the
project5 it sends it to the cabinet for its approval
8. *he cabinet generally accepts the recommendation of the PIB and
approves its implementation.
SU--ARY
□
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.
□
*ill the middle of the sixties the mechanism for appraisal and selection of public
sector projects was rather primitive. *o improve the 7uality 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).