Dev 567
Project and Program Analysis
Lectures 6: Economic Appraisal of Projects
Dr. M. Fouzul Kabir Khan
Professor of Economics and Finance
North South University
Lecture 6
• Analyzing economic costs and benefits in an existing
market
• Evaluation of costs and benefits in distorted markets
• Direct estimation of demand curve
• Extrapolation and econometric estimation
Analyzing Economic Costs and Benefits in an
Existing Market
(a) Total Economic Benefit
(b) Total Economic Cost
Price in Rand/Unit
Price in Rand/Unit
Pmax
Pmax
Consumer
surplus
Supply
Pm
C
Pm
Demand
0
Qm
E
0
Units of Output
(c) Total Economic Benefits and Costs
Price in Rand/Unit
Pmax
Pm
Supply
C
Demand
E
0
C
Qm
Units of Output
Qm
Units of Output
Producer
surplus
Analyzing Economic Costs and Benefits in an
Existing Market
 The gross economic benefits from the consumption of the
output from this industry are greater than the financial
revenues received by the suppliers due to the consumer
surplus enjoyed by the consumers of the output.
 Economic cost of producing the output is less than the
financial revenues received by the suppliers due to the
producer surplus enjoyed by the suppliers.
 The implication of these two facts is that the financial price of
a unit may be different from its economic price even in the
absence of distortions.
Analyzing the Economic Benefits of an Output
Produced by a Project

Valuing Project outputs



Elastic demand, or a small project

Use market price

Quantity supplied by the project *market price
Perfectly inelastic supply


Will depend on the nature of the market in which the output is traded.
Use average of before and after project prices, area under the demand
curve in the range of change in project output.
How to find price after the project?
Analyzing the Economic Benefits of an Output
Produced by a Project
Analyzing the Economic Benefits of an Output
Produced by a Project
Analyzing the Economic Benefits of an Output
Produced by a Project
Economic Benefits of a New Project in an Undistorted Market:
Upward sloping supply (a large project)
Analyzing the Economic Benefit of an Output (subject to tax)
Supplied by a Large Project
Analyzing the Economic Cost of an Input
Demanded by a Project (Cont’d)
• If the quantity demanded by the project is relatively small
compared to the size of the market then there will only be a
very small change in the market price.
• In such a situation and given that we are operating in an
undistorted market, the gross financial cost to the project will
be equal to the gross economic cost.
• A difference only arises when the change in the quantity
demanded by the project is sufficiently large to have a large
impact on the prevailing market price.
Analyzing the Economic Cost of an Input Demanded by
a Project
Economic Cost of an Input Demanded by a Project in an
Undistorted Market: Elastic supply, large market or a small project
Analyzing the Economic Cost of an Input
Demanded by a Project (Cont’d)
• If the quantity demanded by the project is large compared to the
size of the market then there will only be a change in the market
price.
• Government purchasing land
– Purchase price, P2*(q-q1)
– Economic costs
• Land taken through eminent domain
– Economic costs
P1  P2
* (q  q ' )
2
Pres  P2
* (q  q ' )
2
Analyzing the Economic Cost of an Input
Demanded by a Project
Economic Cost of an Input Demanded by a Project in an
Undistorted Market: Inelastic supply
Analyzing the Economic Cost of an Input Demanded by a
Project
Economic Cost of an Input Demanded by a Project in an
Undistorted Market: Upward sloping supply curve and a large Project
Analyzing the Economic Cost of an Input (subject
to tax) Demanded by a Project
• Large project subject to purely revenue generating input tax
• General principles:
– When a project reduces the quantity of input available for other
people, use the willingness to pay (as indicated by the demand
curve) as value
– When a project increases the quantity of input that the market
must produce, use marginal cost for the value of the added
input
– Tax is treated as transfer
Analyzing the Economic Cost of an Input
(subject to tax) Demanded by a Project
Class Exercise
 A project uses large quantity of cements to build a bridge.
Cements are subject to a Tk. 1/bag tax and 100 million bags
will be used to build the bridge. As a result of the bridge, the
price of cement including the tax, will rise to from Tk. 2 to Tk.
2.30 per bag and private consumers are expected to decrease
their consumption by 20 million bags. What costs should be
attached to this input?
Analyzing the Economic Cost of an Input (subject to
taxes related to externalities) Demanded by a Project
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.
Valuation of Benefits in Distorted Markets
• If market or government failures distort the relevant product
market, then project benefits are measured by the changes in
social surplus resulting from the project plus net revenues
generated by the project
• Monopoly
– As in the competitive case, the social surplus generated by
the output produced and sold in the monopolist is
represented graphically by the area between the demand
schedule and the marginal cost curve that is to the left of
the MR and MC curves
Valuation of Benefits in Distorted Markets
◦ Social surplus above the price is received by the consumers and
that below the price is captured by the producer.
◦ Monopolist is a part of the society; therefore benefits accruing
to them count.
◦ Breaking the monopoly will increase social surplus;
 Deadweight loss would disappear.
 Consumers will capture a part of the monopolists
producers surplus, viewed as transfer.
Valuation of Benefits in Distorted Markets
Valuation of benefits in Distorted Markets

Natural Monopoly

Four policies
1.
Allow monopoly, deadweight loss abc, monopoly profits=Pmafg.
2.
Regulate monopoly, set PR = AC, eliminates monopoly profits, transferring
social surplus to persons using the road, expands output, reduces
deadweight loss from area abc to area dec, society’s benefit adeb.
3.
Require road authority to set Pc , eliminates deadweight loss, price is less
than AC, revenue no longer cover costs, subsidy would be required.
4.
Free access, marginal costs exceed willingness to pay, deadweight loss
chQo, no toll revenue, entire construction and operation costs have to be
subsidized.
Valuation of Benefits in Distorted Markets


Information Asymmetry
Externalities

Negative Externality




Too low price, too much output, deadweight loss
Impose tax t
Social accounting ledger
Positive Externality
Too high price, too little output
 Provide subsidy v
 Social accounting ledger
Public goods



Little or none will be produced, willingness to pay, optimal level of output of public
goods
Valuation of benefits in Distorted Markets
Valuation of benefits in Distorted Markets
Valuation of benefits in Distorted Markets
Measuring Costs in Inefficient Markets

Purchase at below opportunity costs


e.g. witnesses, commuting costs, lost labor
Hiring unemployed labor

Five alternative measures of social cost of hiring unemployed labor
Zero opportunity costs, other productive work, value of leisure,
value of time: Pe, Pc,Pd, Pd, Pr. Opportunity cost should be non-zero
 Budgetary expenditure, workers were willing to work for less,
subtract producers surplus, transfer to the workers
 Area cdLdLt
 ½(Pm+Pr)(L’)
 ½(Pm)(L’), assumes Pr to be zero
Purchases from a monopolist


Measuring Costs in Inefficient Markets
Measuring Costs in Inefficient Markets

The general rule

In factor markets in which supply is taxed, direct expenditure outlays
overestimate opportunity cost

In factor markets in which supply is subsidized, direct expenditure outlays
underestimate opportunity cost

In factor markets exhibiting positive externalities of supply, expenditures
overestimate opportunity costs

In factor markets exhibiting negative externalities of supply, expenditures
underestimate opportunity costs
Opportunity cost equals direct expenditure in the factor
market minus (plus) gains (losses) in social surplus
Occurring in the factor market
Benefits and Cost of Traded Goods and Services
• Trade effects of outputs
– Extra export
– Less imports
– A combination of the two
• Trade effects of inputs
– More imports
– Less exports
– A combination of the two
• Economic benefit of exported/importable output
• Economic cost of imported/exportable input
Economic Prices of Traded Goods and Services
Economic Prices of Traded Goods and Services
Valuing Impacts from Observed Behavior
• In project analysis we estimate change in social
surplus to value impact of the program/project
– Need to know the shapes of the supply and
demand curves
• There are well functioning competitive markets,
know only one point on the demand and supply
curves, represented by the equilibrium
Valuing Impacts from Observed Behavior
• Goods that are rarely traded in markets-health
and safety, pollutions, access to scenic areas
• Commodities that are traded in imperfect
markets, monopoly, asymmetric information,
and externalities
Demonstrations
•
•
Estimating benefits and cost based on demonstration or pilot programs.
Alternative evaluation designs:
– Classical experimental design with or without baseline data
– Simple before and after comparison
– Non-experimental comparison with or without baseline data
•
Limited applications:
– Employment and training programs, people oriented service
– A new dam, on a small scale, pilot basis cannot be done
•
Advantages:
– A bad idea can be abandoned
– Needed adjustment in the program may be made
•
Disadvantages:
– May not readily translate into a large-scale program
– Uncertainty concerning external validity
Direct Estimation of Demand Curves
 Three possibilities
• Knowing one point on the demand curve and its
slope or elasticity.
• Extrapolating from a few points, know a few points
on the demand curve that can be used to predict
another point of relevance to policy evaluation.
• Econometric estimation with many observations,
have a sufficient number different observations of
prices and quantities.
Exercise
• Current refuse disposal is 2.6lbs per person per day and
disposed off in containers of 20lbs
• Currently there is no charge on refuse collection
• Marginal social cost (collection + landfill costs) = 0.6/lb
• In new Delhi for each Rupee increase in price of refuse
collection reduces wastes by 0.4 lb/p/d
• Assume a linear demand curve
• Evaluate impact of imposition of a fee of 0.05/lb, i.e. Tk. 1
for each container of 20lbs, MPC is less than MSC
Using a Slope Estimate

Linear demand curve
q   0  1 p
Slope or elasticity estimates from previous research
Assuming α0 = 2.60, α1= - 0.4
 Estimating social surplus gain from charging for refuse
disposal

◦ A graphical illustration
Social Surplus Gain from Refuse Fee
Using an Elasticity Estimate
• We have an estimate of price elasticity of demand from
previous research
–
–
–
–
εd = α1 p/q
α1 = εd q/p
εd=-0.12
p = 0.81, and q = 2.62, α1 = -0.40
• Construction of a linear demand curve to measure changes in
social surplus requires either a direct estimate of the slope
itself or an estimate of the price elasticity of demand and the
price and quantity at which the elasticity was estimated.
Extrapolation and Econometric Estimation
• Effect of a fare increase on bus ridership
– If the past fare increase of Tk. 1 resulted in 1000 fewer riders , then it
may be reasonable to assume that a further increase of Tk.1 will have
the same effect
– Assumed functional relationship between the outcome and the policy
variable
• Linear functional forms can produce very different predictions
than constant-elasticity functional forms
• Further we extrapolate from past experience, the more sensitive
are our predictions to assumptions about functional form
• Econometric estimation with many observations
– If many observations of quantities demanded at different prices are
available, then it may be possible to use econometric techniques to
estimate demand schedule
Market analogy method
•
•
•
Government supply many goods that are also provided by the private sector,
e.g. education
Using price and quantity of an analogous private sector good to estimate the
demand curve for a publicly provided good
The market price of a comparable good in the private sector is an appropriate
shadow price for a publicly provided good, if it equals the average amount
that users of the publicly provided good will be willing to pay
– Private and public goods must be comparable in quality of service and
other important characteristics
– Limitations:
• Using private sector revenues would underestimate benefits, because
it omits consumer surplus
Market analogy method
• Using the market analogy method to value time saved
– Bridge, highway improvement saves time
– Wage rate
– Limitations of wage rate
• Benefits, should be added to wages
• People work during travel
• Truck drivers work, to be counted,
wage + benefit
• Taxes, After tax wage rate plus benefit
• Pleasure travel
• Dirty, dangerous jobs, unemployed
Exercise I
 Using Airbags in car would increase probability
of survival in a accident from p to p + w.
 Additional cost of an airbag is Tk.1,000
 W=1/1000
 Calculate value of life.
Exercise II
 One type of construction job has a 1/1000 greater
chance of a fatal injury in a year than another type of
construction job.
 Suppose riskier job pays a salary that is Tk. 2000 higher
than the safer job
 Calculate value of life.
Market analogy method
 Using the market analogy method to value life saved
– Foregone earnings method
• Value of life saved equals the present value of future earnings
– Consumer purchase studies
(p+w)V(Life) –Tk. 1000 = pV(life)
(p+w)V(Life) - pV(life) = Tk. 1000
wV(life) = Tk. 1000
V(life) = Tk. 1000 /w, w =1/10,000
V(life) = Tk. 1000 /(1/10,000)
= Tk. 10,000,000
– Labor market studies
(1/1000) V(life) = Tk. 2000
V(life) = Tk. 2 million
Intermediate Good and Asset Valuation Method
 Intermediate good method
– If the output from a project is to be used as an input into the production
of some other good, then the effects on profits of the other, downstream
industry can be included as a benefit, e.g. irrigation, education and
training, value added
• Excludes consumer surplus
• Double counting, demand curve for water, benefits to farmer
 Asset valuation method
– Increase or decrease in the property value following implementation of a
project, e.g. location of jail, park
• Ex post CBA
• Assumes other factors remaining the same
• Not applicable in case of mobile assets
Travel Cost Method
• Used in valuing recreational sites
• Steps in travel cost method
– Visitors from different origins bear different travel costs depending on
their proximity to the site
– The resulting differences in total cost, and the differences in the rates of
visit that they induce provide a basis for estimating demand curve for the
site
– Select a random sample of households within the market area of the site
– Survey the households to determine their number of visits to the site over
some period of time, all of their costs involved in visiting the site, the cost
of visiting substitute sites, their incomes, and their other characteristics
– Specify a functional form for the demand schedule and estimate it using
the survey data
Illustration of the Travel Cost Method
Zone
Travel
Time
(hours)
A
0.5
B
Actual
total
cost per
person
(Tk.)
Average
number
of Visits
per
Person
Consumers
Surplus per
Person
Consumers
Surplus per
Zone (Tk.
thousands)
Trips per
Zone
(thousands)
2
20
15
525
5,250
150
1.0
30
30
13
390
3,900
130
C
2.0
90
65
6
75
1,500
120
D
3.0
140
80
3
15
150
30
E
3.5
150
90
1
0
0
10
10,800
440
Total
Travel
Distance
(km)
Travel Cost Method