Economic Analysis
Key Questions
What do we mean by ‘Economic Analysis’?
Why do we need ‘ Economic Analysis’?
What should be considered in an ‘Economic
Analysis’?
What is Economic
Analysis?
Economic Analysis of a project is to
assess the social profit by
measuring the effects of the project
on the fundamental objectives of
the whole economy.
Why do we need Economic
Analysis?
We adopted Economic Analysis to
measure the social profit instead of
money profit itself.
Economic Analysis of a project provides
the decision-maker to allocate their
resources more efficiently and
effectively.
What should we consider
in an Economic Analysis?
Enumeration of Cost and Benefit
Measurement of Cost and Benefit
Thus it is called CBA.
Economic Analysis: Cost-Benefit
Analysis
Cost-Benefit Analysis (CBA) is a set of
procedures for defining and comparing
benefits and costs.
Decisions are made by decision makers, and
benefit-cost analysis is properly regarded as
an aid to decision making and not the
decision itself (Zerbe/Dively 1994).
Cost and Benefit Analysis
Cost-Benefit Analysis involves the
consideration of Social Benefits and Social
Costs, so it is widely used in evaluating and
assessing many government projects and
decisions.
In CBA, the Willingness to Pay or to Accept as
measured by the Compensating and
Equivalent Variations is the correct theoretical
measures for welfare changes.
Examples of Public
Projects: using CBA
Pricing non-market goods is common.
 Community and public goods.
where “free riders” cannot be excluded.
 Intangible externalities,
e.g noise and congestion cost, human
lives saved, the pleasure derived by
passers-by from flowers and trees in
private gardens.
THE CBA Approach
Most basically,
 list all relevant items
 Value expected benefits and costs
 Discount the future flow of benefits and
costs
 Appraise the project by setting off
aggregate benefits against aggregate
cost
Willingness to Pay and to
Accept
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Willingness to pay for a good or to avoid cost is
subject to the budget.
Willingness to accept payment to forego a good or to
bear cost is different from willingness to pay and it
could be infinite.
Compensation Variation and Equivalent Variation
could be adopted to measure the above two
concepts.
Consumer Surplus
Consumer Surplus is approximately the amount one would pay for the good,
over what one does pay, rather than do without the good (Zerbe/Dively 1994).
P
Figure 1
A
P0
CS
B
D0
.
Q0
Source : Adapted from Richard O. Zerbe. Jr. and Dwight D. Dively. 1994. Benefit-Cost Analysis In
Theory And Practice. New York: Harper Collins College Publishers, pp. 84.
A: Consumer Surplus
B: Payment
Producer Surplus
Producer Surplus is an amount that can be taken from the producer or
input supplier without diminishing the amount supplied.
Figure 2
P
S
0
P0
PS
Xo
X
Source : Adapted from Richard O. Zerbe. Jr. and Dwight D. Dively. 1994. Benefit-Cost Analysis In
Theory And Practice. New York: Harper Collins College Publishers, pp. 88.
Measures of willingness to Pay,
Willingness to Accept, Consumer
Surplus and Producer Surplus
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Social benefits and costs are important to evaluate a
project as well as important to the policy maker as an
reference in undertaking public projects.
In evaluating the Willingness to Pay and Willingness
to Accept, we can adopt the Compensating and
Equivalent Variations for measurement.
Compensated Demand Curves and Compensating
Supply Curves for facilitating our assessment.
Compensating Variation
It gives the maximum (minimum)
amount of money that can be
taken from (must be given to) a
household so as to leave it just well
off as it was before a fall (rise) in
price.
Equivalent Variation
It provides the minimum
(maximum) amount of money that
must be given to (taken from) a
household to make it as well off as
it would have been after a fall
(rise) in price.
Summaries of Compensating
Variation and Equivalent Variation
Compensating Variation
Money which can be taken
or given to leave one as well
off as before the economic
change
Amount he/she would be
Welfare willing to pay for the change
Gain
(finite – limited by his
(benefit) income)
Amount he/she would be
Welfare willing
to
accept
as
Loss
compensation for the change
(cost)
(could be infinite)
Equivalent Variation
Money taken or given that leaves
one as well off as after the
economic change
Amount he/she would be willing
to accept to forego the change
(could be infinite)
Amount he/she would be willing
to avert the change
(finite – limited by his income)
Source: Adapted from R. Layard and A.A. Walters, Microeconomic Theory, McGraw
Hill: New York, 1978, pp.150-152
Expenditure Functions
Expenditure Function is commonly adopted as expressions in
much of modern welfare theory.
For a price decrease P 01> P 11,, so that CV > 0
CV = C[P 01, P 02, U 0)] - C[P 11, P 02, U 0)]
P
Compensation
Variation
a
P1
A
CV
b
P2
D0
H1 (U1)
X4
X3
X2
X1
H2 (U2)
X
Expenditure Functions
(Cont’d)
For a price change P 01 to P 11,
EV = C[P 01, P 02, U 1)] - C[P 11, P 02, U 1)]
P
a
P1
A
Equivalent
Variation
C
EV
b
P2
B
X
D0
H1 (U1)
X4
X3
X2
X1
H2 (U2)
The Rate of Discount
Adopted when we have to
forego current consumption
presently and obtain the
benefits of the project in the
future.
Social Opportunity Cost Applied when we are
Rate of Interest (SOC) estimating the future
consumption foregone by
not taking the alternative
investment.
Social Time Preference
Rate (STP)
Risk and Uncertainty
Adding premia to the discount rate is a
widely adopted principle.

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However, not all phenomena exhibit the
pattern of ‘riskness’.
A minor technical adjustment make a
possible error in estimating individual
items.
Economic Analysis for
consideration
Steps involved
1. Identify benefits and costs, and quantify
2. Include shadow pricing and opportunity cost, if
necessary
3. Apply evaluation methods as in financial appraisal,
e.g.
- Discount Cash Flow
- Net Present Value
- Internal Rate of Return
- Benefit-cost ratio
Methods of Economic
Analysis (Cont’d)
4. Apply sensitivity and risk analysis
Present worth of the expected net social benefit = i=1 PiXi
Where Pi = Possibility of an event,Xi = Expected net social
benefit
Example
There is an existing old and poor single-two road
running between Town A and Town B. There is a
proposal to construct a new highway to relieve the
increasing traffic on the road. After considering all
constraints, a new route has been drawn up for
constructing the highway to connect the two towns,
crossing a crop field. Identify the social benefits
and social costs of the proposed highway project.
Example (Cont’d)
Social benefits
1.
2.
3.
4.
5.
Less fuel used by vehicles
Less traveling
Reduction of maintenance and repair costs to existing road
Fewer injuries to pedestrians
Benefits from greater business turnover
Social costs
1. Costs of resources committed
2. Maintenance and repair costs to new highway
3. Loss of crop production
Difficulties with a CBA
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Allowing for the distributional effects
Adjusting market prices to allow for
indirect taxes
Estimating the ‘willingness to pay’ for
intangibles which are market non-priced
Choosing the appropriate discount rate
Providing for risk and uncertainty
Conclusion
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Like a private investor, the public sector is also concerned
about the financial implication of its investments.
Market prices do not fully reflect the true costs and benefits
of an investment, largely due to market failure and
imperfection.
Such external effects should therefore be dealt with in
economic analysis (always economists refer it to as “costbenefit analysis”.
A financially viable project may not necessarily be
economically feasible.