Lecture Notes
ECON 437/837: ECONOMIC
COST-BENEFIT ANALYSIS
Lecture Two
1
PRINCIPLES UNDERLYING THE
ECONOMIC ANALYSIS OF
PROJECTS
2
Interface of Project with the Markets
Factor Markets → Project → Output Market
(Labor & Capital)
The role of microeconomics in project evaluation is to
determine economic benefits or economic costs, which differ,
more often than not, from financial benefits or financial Costs.
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 $1,000
investment and NPV equals to $ -270. Then the project uses $1,000
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, e.g. road usage, water.
2. financial costs may not be the true costs, e.g. 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. These market
distortions can often be combined and expressed as
a proportional distortion D.
(1  D ) 
Economic value
Financial
(1  D )  Conversion
value
Factor
Where the combined rate of the
distortions D is expressed as a
proportion of the financial price
6
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.
CSCF i =
Economic
Value
Financial
Price
• 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.
CSCF Cotton
Yarn
=
R 18 , 794
R22,239
= 0 . 85
7
Example of Financial and Economic
Cashflows: the Case of Electricity Project
Table of Parameters for Financial Analysis
Table of Parameters for Economic Analysis
Price of Electricity
Production of Electricity
2.20 Rs/Kwh Long term investment
1,500 Gwh/year Machinery
8,000
Equipment
1,290
Gas
0.25 per Kwh Financial Cost
Land (Given as subsidy) 300
of Capital
12%
Coal
0.15 Rs/Kwh
Cashflow: Financial Points of View (millions Rs.)
Year
2001 2002 2003
Inflows
Sales
3300 3300
Land (Subsidy)
300
Liquidation value of investment
Liquidation value of land
Total Inflows
300 3300 3300
Outflows
Land
Long term investment
Machinery
Equipment
Gas
Coal
Labor Wages
Total Outflows
9,590
Net Cashflows
NPV @12%
-9290
-1283
Willingness to pay for electricity
Economic Opportunity cost of Labor
Foreign Exchange Premium
Subsidy on Gas
Economic Opportunity cost of capital
Resource flow: Economic Points of View (millions Rs.)
2004 2005 2006
3300 3300
0
300
3300 3300 300
300
8000
1290
375
225
120
720
375
225
120
720
2580
2580
3.00 Rs/Kwh
80% of financial wage bill
15%
30% of Financial Cost
10%
375
225
120
720
375
225
120
720
0
2580 2580 300
Year
Inflows
Sales
Land (Subsidy)
Liquidation value of land
Total Inflows
Outflows
Land
Long term investment
Machinery
Equipment
Gas**
Coal
Labor Wages
Total Outflows
CF*
0.00
1.00
2001
1.00
300
1.15
1.15
1.50
1.15
0.80
9200
1484
**CF for gas = [(1.3)*(1.15)]/1 = 1.5
2003
2004 2005 2006
4500
4500
4500 4500
4500
4500
300
4500 4500 300
0
0
Net Cashflows
NPV @10%
*CF = Conversion Factors
2002
0.00
560.63 560.6 560.6 560.6
258.75 258.8 258.8 258.8
96
96
96
96
10,984
915
915
915 915
-10984
566
3585
3585
0
3585 3585 300
8
Three Postulates Underlying the Economic
Evaluation Methodology
•
These postulates are based on a number of
fundamental concepts of welfare economics.
1) 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.
2) The competitive supply price for an incremental unit of
a good or service measures its economic resource
cost.
3) Costs and benefits are added up without regard to who
the gainers and losers are.
9
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.
Economic Value of Local Calls for
Rural Customers
Tariff /Coping
Cost (US$/minute)
(MWTP)
P0 = 0.280
A
Consumer Surplus
(P1AC)
C
P1 = 0.120
Payment
for
services
Demand
Q0
Q1
Data Traffic (minutes/ year)
Economic value = Q0ACQ1 = Willingness to Pay
10
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.
Suppliers will be indifferent between selling
incremental units of the good at their supply
prices and using the factors to produce other
goods and services.
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.
Installation (Marginal Cost) of one
more terminal and demand for rural
telephone calls
Cost
MC
D2
D1
O
Q0
Q1 Q2
Number of rural telephone calls
11
The implication of these postulates for
the economic analysis of a project (Cont’d)
Third Postulate
• Costs and benefits are added up without regard to who the gainers
and losers are.
– Focus on economic efficiency
• 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.
• This approach attempts to separate the social aspects of project
appraisal from the economic efficiency aspects.
12
Measuring Economic Benefits of a
Project’s Output
• Output from a project affects the market
equilibrium. The changes in quantity
demanded, quantity supplied and price
translate into cost savings due to cuts in
production of inefficient producers and an
increase in consumption because of lowering
of the market price.
13
Economic Benefits of Project Output (No Distortions)
Price
S0
A
S0 + Project
C
P0m
P1m
G
F
E
B
Economic Value
= WxsPs+WxdPd
If no output market distortions,
then:
Ps = Pd = Pm
D
D0
Q s Q0
1
Quantity
d
Q1
QT
Financial benefit is P1m (Q1d-Q1s)
Economic benefit is Q1sGCQ0 + Q0CFQ1d
Value of
Resources
Saved
Value of
Increased
Consumption
14
Measuring the Economic Costs of a
Project’s Inputs
• A project requires inputs for production.
Demand of inputs by the project deprives
some consumers in the market because of
an increase in the market price. The rise in
the market price invites additional
investment in input markets, depriving
funds for other sectors. These costs
together constitute project’s gross
economic costs.
15
Economic Costs of Project Input
(No Distortions)
Rand/Unit
D0+P
D0
S0
C
P1m
A
B
m
P0
0
d
s
Q0 Q1
Q1
d
s
Financial Cost  Q 1 CA Q 1
e
s
s
d
P W P W P
whe re, P 
Value of
additional
resources
Units
s
d
Economic Cost  Q 0 BA Q 1  Q 1 CBQ
0
d
m
s
Value of
postponed
consumption
m
P0  P1
2
m
P
d

m
P0  P1
2
16
Small versus Large Changes in Prices
• Often the quantity produced by a single project or purchased 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.
17
Weights expressed in terms of elasticities:

Supply Elasticity
Wxs =
Wxd =
Wxs
Wxd
Supply Elasticity - Demand Elasticity
=
- 
Demand Elasticity
-
=
Supply Elasticity - Demand Elasticity

=
-
- 
 = (defined positively) own price elasticity of supply
 = (defined negatively) own price elasticity of demand
These are long-run elasticities of demand and supply.
They are an average elasticity representing for the adjustments made by
the market.
18
Calculating the Economic Value of Non-Tradable Goods
Economic Value = Wxs P s + Wxd P d
= weighted average of supply (Ps) and demand (Pd) price
Where:
Ws + Wd = 1
• If rationing then
Ws = 0 and Wd = 1
• Traded: Importable Ws = 1 and Wd = 0
Exportable Ws = 0 and Wd = 1
• Non-traded
Ws  0 and Wd  0
Three classes of goods:
Ws
Wd
2/3
1/3
1/2
1/2
1/3
2/3
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
1. Sales Taxes Levied on Output of Project
Economic Benefit of an Output Supplied by a Project
--- when a tax is imposed on sales --R and/U nit
d
B'
P0
Ws P0m + Wd P0m(1+t)
S0+ P
A'
d
P1
Economic Benefits
S0
B
m
P0
C
m
P1
A
D0
D
s
d
Q0
Q1
0
n
Q1
Financial benefit is P1m (Q1d-Q1s)
e
s
s
d
P = W P +W P
d
U nits
Value of
Resources
Saved
Value of Increased
Consumption
Economic benefit
is Q1sCBB’A’Q1d
m
P0
Example d
s
m
whe re, P = P0 * (1 + K )
P =
m=120, t =0.15
(1 +PK)
Wx s =1/3, Wx d=2/3
x
Pd = Pm + T if unit tax
Pd = Pm(1+t) if ad valorem
Pe = 1/3(120) + 2/3(120)(1+0.15) = 132
Pe = 40 + 80(1.15) = 132
21
2. Subsidies on Production
Economic Benefits of a New Project
-- when a production subsidy is present -S0
R a n d /U nit
S s = S 0 + S u b si
D0
dy
S s+ P
B'
s
P0
A'
P
B
m
0
C
A
m
P1
s
d
Q0
Q1
0
Q1
U n its
Value of
Resources
Saved
Value of Increased
Consumption
Financial benefit is P1m (Q1d-Q1s) Economic benefit is Q1sA’B’Q0+ Q0BCQ1d
e
s
s
d
P W P W P
d
s
Or if subsidy is proportion of total cost,
P 
s
P
m
1 K
and
m
whe re, P  P0 * (1  K )
P  P
d
m
Example
Wxs =1/3, Wxd=2/3 Pm=120, K=0.40
Pe = 1/3(120/(1-0.40)) + 2/3(120) = 146
22
3. Sales Taxes Levied on Input of Project
R and /U nit
Economic Cost of an Input Demanded by a Project
--- when a tax is imposed on sales ---
d
C'
P1
B'
d
P0
S0
A
m
P1
P
C
m
0
B
D0
D n+P
+TA X
D
d
Q1
0
Q0
s
Q1
n
Value of
postponed
consumption
Value of
additional
resources
+TA X
U nits
Financial cost is P1d (Q1s-Q1d) Economic cost is Q1dC’B’ Q0 + Q0 BAQ1s
P e = W s Ps + W d P d where P d = P0m (1+ t)
Example
Wxs = 0.25, Wxd = 0.75, P0 m = 90, t = 0.15
Pe = 0.25[90] + 0.75 [90(1+0.15)] = 100
23
4. Production Input Subsidized
Economic Cost of an Input Demanded by a Project
--- when an input subsidy is present ---
Price
S0
H
s
m
C
P 1 = P 1 / (1-k)
After Subsidy
G
P
s
0
= P
m
0
/ (1-k)
S
B
D
P
P
d
1=
d=
0
P
m
1
P
m
0
Value of
Additional
Resources
Value of
Postponed
Consumption
0
I
E
F
J
A
D0+Project
D0
d
Q1
Financial Cost is
Q
0
P1m
Q
s
Quantity
1
(Q1d-Q1s)
Example
Wxs = 0.25, Wxd = 0.75, Pm = 90, k = 0.40
Pe = 0.25[90/(1-0.4)] + 0.75(90) = 105
Economic Cost is Q1dEFQ0 + Q0GHQ1S
Economic Costs
m
P
Wxs x0 + Wxd P
(1-k)
m
x0
24
5. Sales Tax and Production Subsidy on Input
Economic cost of a Project
-- When a production subsidy and a sales tax are present -S0
Pz
P1d=P1m (1+tz)
P1s=P1m/(1-kz)
P0d=P0m (1+tz)
P0s=P0m/(1-kz)
P1m
P0
B
C
S0+subsidy
M
L
G
R
N
J
U
H
D0
E
m
Dn+P
Dn
A
0
Value of postponed Value of additional
consumption
resources
Q1d
Q1s
Q0
Financial Cost is P1m (Q1d-Q1s)
P = W P +W P
e
s
s
d
d
Q2d
Qz
Economic Cost is Q1dMGQ0 + Q0RLQ1s
P1m
where, P =
1- ks
s
P d = P1m (1+ ts )
Example
Wxs = 0.25, Wxd = 0.75 P0m = 90, t = 0.15, k = 0.4
P1s = 90/(1-0.4) = 150 , P1d = 90(1+0.15) =103 , Pe = 0.25(150) + 0.75(103) = 114
25
Economic Value of Increase in Quantity Demanded of an Input in the
Case of the Infinite Supply Elasticity
- Example of Electricity Supply by Thermal Generation Price
Ps=Pm
D0+P
D0
Q0
Q1
Quantity
• Project demand (Q1 – Q0) of a non-tradable input
• Ws = 1 and Wd = 0
• If no direct subsidy then Ps = Pm
26
6. Environmental Externalities
A Project with Pollution in the Lake
SC = S0 + Externality Cost
Price
B'
S0 = MPC
S0+P
A'
B
m
P0
A
m
P1
C
D
0
Financial benefit is P1m (Q1d-Q1s)
0
s
Q1
Q0
d
Q1
Quantity
Economic benefit is Q1sA’B’BCQ1d
27
Relationship between Market Prices and Demand
and Supply Prices under Various Types of Distortions
Case
Type of Tax or Subsidy
1
Percentage sales tax(ts) levied on market price at
retail level
Unit (specific) sales tax (Ts) levied on market price at
retail level
Value added tax (VAT) on market price of final
output
Value added tax (VAT) on price of input*
Percentage subsidy (K) given on total resources spent
on production
Unit subsidy (Ku) given per unit of output produced
Ps = Pm
Pd = Pm(1+ ts)
Ps = Pm
Pd = Pm + Ts
Ps = Pm
Pd = Pm(1+ VAT)
Ps = Pm
Pd = Pm(1+ VAT)
Ps = Pm/(1-K)
Pd = Pm
Ps = Pm + Ku
Pd = Pm
Percentage subsidy (K) given as a percentage of
market price
Percentage tax (t p) levied at producers level
Unit tax (Tp) levied at producers level
Two percentage taxes (t1) and (t2) levied on output at
retail level, (compounded)
Ps = Pm (1+K)
Pd = Pm
Ps = Pm/(1+tp)
Ps = Pm - Tp
Pd = Pm
Pd = Pm
Pd = Pm(1+t1)*(1+ t2)
2
3
4
5
6
7
8
9
10
Supply Price
Ps = Pm
Demand
Price
28
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.
29
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.
30
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.
31
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 economic cost of employment 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.
32
Valuation of Non-Market
Goods/Services
• Revealed preference method: using the
data obtained by observing the actual
choices made by individuals in related
markets.
• State preference method: refer to direct
survey approach to estimating the value
placed on non-market goods or services.
33