0 Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Six

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Lecture Notes

ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS

Lecture Six

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ECONOMIC VALUATION

OF TRADABLE GOODS &

SERVICES

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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.

• 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.

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Tradable Commodities

A good or service is considered tradable when an increase in demand (or supply) by a project does not affect the amount demanded by domestic consumers.

• An increase in demand for an IMPORTABLE commodity results in an increase in demand for imports.

• An increase in demand for an EXPORTABLE commodity results in a reduction in exports.

• An increase in supply of a tradable commodity by a project will cause either a reduction in imports or an increase in exports.

An Importable commodity includes imported goods and domestically produced goods that are close substitutes for imported goods.

An Exportable commodity includes exported goods and close substitutes for exported goods.

• There are usually more internationally traded goods and services than non-traded goods and services in economy.

• Smaller countries tend to have more traded goods and services than large countries. Small countries cannot produce many goods and services efficiently.

• The public sector tends to produce non-traded goods and services but uses many traded goods and services as inputs.

• E.g., when analyzing infrastructure projects that produce domestic services, the techniques for the economic valuation of tradable goods are important for determining the economic cost of inputs to the project.

Tradable Commodities (cont’d)

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Classification of a Project’s Outputs and Inputs

Outputs

Tradable Non-Tradable

Importable Exportable

Inputs

Tradable Non-Tradable

Importable Exportable

Project

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Measuring the Economic Values of Tradable Goods: Four Cases

1. Economic cost of importable input

2. Economic value of importable good production

3. Economic value of export production

4. Economic cost of exportable input

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Importable Good

Distorted World Supply Price

Price

QQuantity per year

domestic supply

domestic demandD

S

Em * PCIF * (1+Tm) + Fm

do

so Q

Pm

Imports = Q - Q

Em = Market Exchange Rate

Tm = Rate of Import TariffFm = Domestic Freight to Market

so

do

PCIF = Price of imports at entry point to country, including international freight

and insurance charges expressed in units of foreign currency

Project Demands More of an Importable Good

Project requirements will be met by additional imports (world supply). Domestic consumption is not affected.

Price

Quantity

S domestic

Qs0 Qd

0 Qd1

D domestic

D w/project

S worldEm * PCIF * (1+Tm) + Fm

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Project Purchases Importable Inputs

Input subject to Import Tariff

Financial cost is EmPw (1+t) (Q1d - Q0

d)

Economic cost is EmPw(Q1d – Q0

d) + Foreign exchange premium

World Supply

Qs0

Price

Pd Pw(1+t)

Pw

S0

Quantity

World Supply After Tariff

D0 D0+P

0 d1QQ d

0

= Em

Em

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Estimating the Economic Prices of Tradable Goods

1. Adjust for commodity - specific trade distortions

• Financial prices for the commodities demanded (or supplied) by a project must be adjusted for commodity-specific distortions and costs that drive a wedge between their international prices and their domestic market prices.

• Taxes and subsidies are transfers between consumers, producers, and the government. Therefore, they are not part of the real resources consumed or produced by a project.

2. Value the foreign exchange at the economic (shadow) exchange rate (Ee)

• Multiply the CIF and FOB prices at the border by the economic price of foreign exchange (Ee).

• Alternatively, add a foreign exchange premium [(Ee/Em) – 1], per unit of foreign exchange demanded (or supplied) by a project.

3. Adjust for handling and transportation costs

• The economic costs of handling and transportation that are necessary to move commodities to or from the point of entry must be included.

• In the case of imported commodities, these costs should be added to the CIF price.

• In the case of exported commodities, these costs should be subtracted from the FOB price.

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Visayas Communal Irrigation Project

Basic Facts• The National Irrigation Administration (Philippine National Agency) proposes to

rehabilitate 55 damaged communal irrigation systems and to build 25 new systems in Visayas.

• The project’s additional components include water protection and erosion control, the strengthening of irrigation association, and the development of agricultural extension services.

• The goal of the project is to alleviate poverty, while improving environmental sustainability of the region.

• The life of project is 20 years.• The economic benefits arise from the increased production of rice and corn, which must

otherwise be imported.

• The foreign exchange premium is 24.6%.• The project is expected to cost approximately 480.91 million pesos (US$19.78 million). • The project will be financed with US$15.1 million loan from the International Fund for

Agricultural Development, and remaining funding would be provided by the Philippine government.

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Project uses an Importable Good (Pesticides)

Farm Local Market

Importer Depot, Manila

Port, Manila

Transport

(+) (+) (+)

Transport Transport Tariff, Port Charges

13

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Quantity of units per year (000’s)

D0

E

0

Price / unit

G

S0

A

B

C

F

D1

S0Q

d0Q

d1Q

(cif)=P1

(P1+tariff)=P2

(P2+trade margin)=P3 (P3+freight)=P4

L M K J

H I

Economic Cost of Importable Goods: With Tariff, Trade Margin and Domestic Freight

Em

Table 1: Project Uses an Importable Good (Pesticides)

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Financial

Price

Conversion Factor for

Nontradable Services

Value of

FEP Economic

ValueCIF World Price per 1000 liters of pesticides

US Dollars 166.00 Local Currency 4,038.00 993.35 5,031.35

Plus: Tariff 201.00 0 Price at Port 4,239.00 5,031.35CF at the Port 1.19

Plus: Handling/Transportation from Port to Manila Markets

Handling 540.00 0.90 486.00Transportation 225.00 1.20 270.00

Plus: Traders' Margin 200 0.7 140.00Plus: Handling/Transportation from Manila Markets to Farm Gate


Price at the Farm Gate 6,054.00 6,767.35CF at the Project Site 1.12






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Project Supplies More of an Importable Good

Project reduces quantity imported. No change in domestic consumption.

Price

Quantity

S domestic

S w/ project

Qs0 Qs

1 Qd0

D domestic

S worldEm * PCIF* (1+Tm) + Fm

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Project Supplies an Importable Good (Rice)

Farm

Wholesaler, Manila

Port, Manila

Farm-gate price of paddy

Grain dealer margin

Transportation & handling

Milling cost

Transportation

Transportation & handling

Trading margin

Price of rice at the port

(+)(-)

(-)

Pre-milled (paddy)

Ex-milled (rice)

Rice Mill

Paddy equivalent (65%)

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Table 2: Project Supplies an Importable Good (Rice)

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Financial

Price



Value of

FEPEconomic

ValueCIF World Price per ton of Rice

US Dollars 314.80 Local Currency 7,659.00 1,884.11 9,543.11

CF at the Port 1.25

Plus: Transportation/Handling Charges Port-Manila Handling 50.00 0.90 45.00Transportation 100.00 1.20 120.00

Traders' Margin 472.00 0.70 330.40 Wholesale Price in Manila 8,281.00 10,038.51Less: Transportation from Rice Mill to Manila 515.00 1.20 618.00 Ex-Mill Price of Rice 7,766.00 9,420.51Less: Milling Cost 345.00 1.10 379.50 Pre Milled Value 7,421.00 9,041.01Paddy Equivalent (65%) 4,823.65 5,876.66Less: Grain Dealer's Margin (4%) 192.95 0.70 135.06 Handling/Transport from Farm to Mill:

Handling 50.00 0.90 45.00 Transportation 80.00 1.20 96.00

Price of Paddy at Farm Gate 4,500.70 5,600.60CF at the Project Site 1.24






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Exportable Good

Quantity per year

Distorted World Demand Price

Price

Q

domestic supply

domestic demandD

S

Em * PFOB * (1-tx) - Fx

do

soQ

Pm

Exports = Q - Q

Em = Market Exchange Rate

tx = Export Tax

Fx = Freight and Trading Costs to Port

do

so

PFOB= Price of exports at point of export from country in units of foreign currency

Project Supplies More of an Exportable Good

Project increases exports. Domestic consumption remains unchanged.

Price

Quantity

S domesticS w/ Project

Qd0 Qs

0 Qs1

D domestic

D world Em * PFOB * (1-tx) - Fx

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Project Produces Exportable Goods subject toExport Tax (No domestic transportation costs)

Pd = Pw(1-t)

Pw World Demand

Price

Quantity

S0+P

D0

World Demand After Export Tax

S0

0 d0Q s

0Q s1Q

Financial benefit is EmPw (1-t) (Q1s-Q0

s)

Economic benefit is EmPw(Q1s – Q0

s) + Foreign exchange premium

Em

Pd=EmPw(1-t)

Economic values of exportable goods are based on the FOB values of demand for exports 23

IRRI Supply an Exportable Good (Seeds)

IRRI Gate Port(-)

Port charges Transportation

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Table 3: IRRI Supply an Exportable Good (Seeds)

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Financial

Price



Value of FEP

Economic Value

Price per ton of Seeds US Dollars 410.00 Local Currency 9,975.00 2,454.00 12,429.00

Plus: Export Subsidy (10% of Price) 998.00 Price at the Port 10,973.00 12,429.00CF at the Port 1.13

Less: Handling/Transportation Charges from IRRI to Port


Price at IRRI Gate 10,803.00 12,261.00CF at the Project Site 1.14






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Project Demands More of an Exportable Good

Project requirements will reduce quantity exported. Consumption of previous consumers remains unchanged.

Price

Quantity

S domestic

Qd0 Qd

1 Qs0

D w/ ProjectD domestic

D worldEm * PFOB * (1-tx) - Fx

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Project Uses an Exportable Good (seeds)

Farm

Local Market

IRRI Exporter

Port, Manila

Transportation

TransportationDealer’s margin

Port Handling Transportation

(-)

(+)

(+)

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Table 4: Project Uses an Exportable Good (Seeds)

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Financial

Price



Value of

FEP Economic

Value

Price per ton of Seeds

US Dollars 410.00

Local Currency 9,975.00 2,454.00 12,429.00

Plus: Export Subsidy (10% of Price) 998.00

Price at the Port 10,973.00 12,429.00

CF at the Port 1.13

Less: Handling/Transportation Charges from IRRI to Port

Handling 120.00 0.90 108.00

Transportation 50.00 1.20 60.00

Plus: Dealers' Margin 370.00 0.70 259.00

Plus: Transportation Cost from IRRI to Farm 635.00 1.20 762.00

Price at Farm Gate 11,808.00 13,282.00

CF at the Project Site 1.12

Summary

Economic Cost of Imported Input = CIF (adj. for economic exchange rate) + Economic Cost of Freight from Port to Project

Economic Value of Importable Good Production =CIF (adj. for economic exchange rate) + Economic Cost of Local Freight from Port to Market - Economic Cost of Local Freight from Project to Market

Economic Value of Exportable Production = FOB (adj. for economic exchange rate) - Economic Cost of Local Freight from

Project to Port

Economic Cost of Exportable Input =FOB (adj. for economic exchange rate) + Economic Cost of Local Freight from Export Producer to Project - Economic Cost of Local Freight from Export Producer to Port

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Additional Examples on

Calculation of Tradable Goods

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Example 1: The Import of Pneumatic Tires (with an import duty)

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Financial

Price



Value of

FEP(15%)

Economic Value

CIF World Price US Dollars 40.00 Local Currency @39 pesos per US Dollar 1,560.00 234.00 1,794.00

Plus: Tariff @30% 468.00 VAT @10% 202.80Price at the Port 2,230.80 1,794.00CF at the Port 0.804

Plus: Handling/Transportation from Port to Project Site

Handling 18.00 0.90 16.20Transportation with Subsidy 9.00 1.25 11.25

Price at the Project Site 2,257.80 1,821.45CF at the Project Site 0.807

Example 2: The Export of Shoes (with an export subsidy)

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Financial

Price



Value of

FEP(15%)

Economic Value

FOB World Price of Shoe

US Dollars 200.00

Local Currency @39 pesos per US Dollar 7,800.00 1,170.00 8,970.00

Plus: Export Subsidy (10% of Price) 780.00

Price at the Port 8,580.00 8,970.00

CF at the Port 1.045

Less: Handling/Transportation Charges from Port to Project Site

Handling 67.20 0.90 64.48

Transportation with Subsidy 80.00 1.25 120.00

Price at Project Site 8,432.80 8,785.52

CF at the Project Site 1.042

Example 3: The Export of Garments (with an export tax)

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Financial

Price



Value of

FEP (15%)

Economic Value

FOB World Price of Garments

US Dollars 800.00

Local Currency @39 pesos per US Dollar 31,200.00 4,680.00 35,880.00

Less: Export Tax (5% of Price) 1,560.00

Price at the Port 29,640.00 35,880.00

CF at the Port 1.211

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MEASUREMENT OF

ECONOMIC PRICES OF

NON-TRADABLE GOODS

Non-Tradable Commodities

• A good or service is considered non-tradable when its domestic price is determined by local demand and supply.

• An increase in demand (or supply) by a project could affect the amounts demanded by domestic consumers (or produced by other suppliers).

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Defining a Price of Non-Traded Good or Service

• Goods and services whose domestic production satisfies all the domestic

demand for these items and whose domestic prices are not affected by their

world prices are referred to as non-traded goods.

Distorted World Supply Price

Price

Quantity per year

domestic supply

domestic demandD

S

Em * PFOB* (1-tx) - Fx

Pm

Em * PCIF * (1+Tm) + Fm

Distorted World Demand Price

Domestic price

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Steps to Estimate the Economic Value of a Non-Tradable Good or Service

1) Adjust for distortions in the market for the item (whether input to, or output of, the project).

2) Adjustment for distortions in market where demand is being diverted towards or away from (wd).

3) Correct for distortions in the markets for the inputs used to produce the item. Correction is applied to the proportion of the item produced by other suppliers in the market (ws).

4) Correct for the foreign exchange premium and the shadow price of non-traded outlays (SPNTO) on tradable and non-tradable components of the non-tradable good or service.

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General Formula for the Estimation of the Economic Prices of Non-Tradable Goods and Services

dx

dx

sx

sx

ex PWPWP

*dPW mx

dx

*)()( ∑∑11

dPWkdPWadPaW mj

djjj

mj

sj

z

j

NTxji

mi

n

i

Txi

sx

xNTPNTxP mx

This formula can be used to estimate the economic price of a non-tradable good, that is either an input used by a project or an output produced by it.

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Step One: Adjusting for Distortions in the Market for Good or Service

dx

dx

sx

sx

ex PWPWP

40

D0

Q00

E

Dn+P

H

Pz

JG

Q2d

P0m

P0s=P0

m/(1-kz)

S0+subsidy

Dn

Q1sQ1

d Qz

BC

N

A

P1m

S0

P1s=P1

m/(1-kz)P0

d=P0m (1+tz)

P1d=P1

m (1+tz) ML

UR

Step One: Adjusting for Distortions in the Market for Good or Service

Economic Costs for Project Input (Input production subsidized and a sales tax is levied on input)

Financial Cost is P1m (Q1

d-Q1s) Economic Cost is Q1

dMGQ0 + Q0RLQ1s

)1( 1 re, wheP

1

d

m

1sddsse

s

m

s

tPPk

PPPWPW

Example

Wxs = 0.25, Wx

d = 0.75, P0 m = 90, t = 0.15, k = 0.4

P1s = 90/(1-0.4)=150, P1

d = 90 (1+0.15) = 103, Pe = 0.25(150)+0.75(103) = 114

Value of additional resources

Value of postponed consumption

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Step Two: Adjustment for distortions in markets where diverted demand moves

*dPW mx

dx

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Step Two: Adjustment for distortions in markets where diverted demand moves

• Amount of diverted demand per unit is

• Because of increased demand by our project, they will shift their consumption to other goods and services. If these goods and services are taxed at an average rate of d*, the additional taxes will reduce the economic cost of good X.

• These additional taxes are denoted as and offset initial cost.

• The economic cost of the non-traded good X now becomes:

• We should note that the larger is the value of d*, the lower will be the

economic cost of a non-traded input used by a project, or the lower will be

economic benefit generated by the non-traded output of a project.

Pe = sxW s

xP + dxW d

xP x

d

xW m

xP d*

*dPW mx

dx

mx

dx PW

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Economic Benefits of Project Output (No distortions on output but input market distorted)

Value of Resources Saved

Value of Increased Consumption

Price

S0 + Project

S0

D0

P0m

P1m

A

C

G F E

B

D

Qs1

d1QQ0 QT Quantity

Economic Value = Wx

sPs+WxdPd

If distortions on markets of input then Pd = Pm but Ps < Pm

Step Three: Adjustment for Distortions (Tariffs, Excise Taxes and Subsidies) in the Markets of the Inputs Used in the Production of a Non-

Tradable Good

Value of distortions on inputs (taxes) no

resource value

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Step Three: Adjustment for Distortions (Tariffs, Excise Taxes and Subsidies) in the Markets of the Inputs Used in the Production of a

Non-Tradable Good

*)()( ∑∑11

dPWkdPWadPaW mj

djjj

mj

sj

z

j

NTxji

mi

n

i

Txi

sx

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Step Three: Adjustment for Distortions (Tariffs, Excise taxes and Subsidies) in the Markets of the Inputs Used in the Production of a Non-Tradable

Good (Cont’d)

• WsPs might overstate or understate opportunity costs if there are taxes or subsidies on the

inputs.

Tradable Inputs• Suppose, in the production of good x, the market of one of its tradable inputs (i) is

distorted by an excise tax.• These taxes are not economic costs.• Need to adjust by

= input-output coefficient showing the quantity of (distorted) input i

used in the production of one unit of x

= market price per unit of input i

di = effective rate of tariff, excise tax or sales tax on input i

This correction is equivalent to substituting the economic values of the inputs (excluding

the adjustment for the FEP) for their financial values. The expression for this adjustment is

written in a more general form in terms of distortions di, as

, di has a positive value if it represents an excise tax, sales tax, import

tariff or a negative value if the distortion is a subsidy.

Pm

i

Txia

)]([ im

iTxi

sx dPaW

)]([ im

iTxi

sx dPaW

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Non-Traded Inputs

• The fundamental objective is to remove any distortions associated with the non-traded

inputs j used to produce a non-traded good X.

• Case I: Tax (dj) on non-traded inputs

In the case where there is just a tax on the purchase of input j, the financial cost of the input will be Pj

m(1+dj) and the economic cost [WjsPj

m + WjdPj

m(1 + dj - d*)] where dj is the

rate of tax on input j and d* is the average rate of indirect taxes on traded and non-traded goods. In this case, Ps = Pm. We wish to subtract the financial costs of input j from the supply price of X and then add back j’s economic cost. The adjustment to the supply price of X for the distortions input j is expressed as:

Simplifying this expression, we have to do adjustment for this tax, d j, on j. Hence, the

value of the distortion cause by the tax adjustment is:

Step Three: Adjustment for Distortions in the Markets of the Inputs Used in the Production of a Non-Tradable Good (Cont’d)

*

*

dPWdPWaW

dPWdPWPWPWdPWPWdPWPWaWmd

jmsNTs

mdj

mdmdmsj

mdmdj

msmsNTs

jjjjxjx

jjjjjjjjjjjjjjjjxjx

*)]1([)1( ddPWPWdPaW jjjjjjjmdmsmNT

xjs

x

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Step Three: Adjustment for Distortions in the Markets of the Inputs Used in the Production of a Non-Tradable Good (Cont’d)

• Case II: Subsidy (kj) and Tax (dj) on non-traded inputs

Suppose instead there is a tax on input of j and also a subsidy on

production of j. Hence, Ps = Pm (1 + kj) and Pd = Pm (1 + dj). The

adjustment will be:

Hence, the value of the distortion created by the tax and subsidy on non-

traded input is:

*)]1()1([)1( ddPWkPWdPaW jjjjjjjjxjxmdmsmNTs

*)( dPWkdPWaW mdmsNTsx jjjjjjxj

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• The expression summing up the distortions in the markets for traded inputs i

(=1 through n), and non-traded inputs j (= 1 to z) is as follows:

Step Three: Adjustment for Distortions in the Markets of the Inputs Used in

the Production of a Non-Tradable Good (Cont’d)

*)()( ∑∑11

dPWkdPWadPaW mj

djjj

mj

sj

z

j

NTxji

mi

n

i

Txi

sx

• The distortion of tax and subsidy on non-traded input is:

when, dj, a tax on non-tradable input, and d* are both positive that will reduce the economic cost of the final non-traded good X but kj is a subsidy on non-tradable supply of input j which is negative and will, thus, increase the economic cost of the final non-traded good X.

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• There will be a need to adjust the proportion of the tradable components (T) of the non-tradable good by the foreign exchange premium (FEP). This is expressed as follows:

– Value of foreign exchange premium (FEP), (FEP = Ee/Em - 1), on the tradable good components of the non-tradable input

= [T Pxm FEP)]

where:

T = proportion of tradable good component of the non-tradable input (x) used by the project expressed as a proportion of the financial market price Px

m

Pxm = market price per unit of output x

Ee = economic exchange rate

Em = market exchange rate

Step Four: Adjust for Foreign Exchange Premium on Tradable Components

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Step Four: Adjust for Shadow Price of Non-Tradable Outlays (SPNTO)

• There will be a need to adjust the proportion of the non-tradable components (NT) of the non-tradable good by the premium of non-tradable outlays (NTP). [NTP = SPNTO – 1].

• This is expressed as follows:

Value of the NTP adjustment for the non-tradable component of the non-tradable input

= [NT Pxm NTP]

where:

NT = proportion of non-tradable good component of the non-tradable input (x) used by the project expressed as a proportion of the

financial market price Pxm

Pxm = market price per unit of output x

NTP = the premium on non-tradable outlays

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General Formula for the Estimation of the Economic Prices of Non-Tradable Goods and Services

dx

dx

sx

sx

ex PWPWP

*dPW mx

dx

*)()( ∑∑11

dPWkdPWadPaW mj

djjj

mj

sj

z

j

NTxji

mi

n

i

Txi

sx

This formula can be used to estimate the economic price of a non-tradable good,

that is either an input used by a project or an output produced by it.

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Price

Q0 Quantity

Ps=Pm

D0+P

D0

Q1ΣiaxioPi

mdi

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 -Project demand (Q1 – Q0) of a non-tradableStep 1Ws = 1 and Wd = 0 If no direct subsidy then Ps = Pm

Step 2With an infinite supply elasticity of electricity, Wd = 0. There is no diverted demand from other goods and services.

Step 3Need to adjust for input distortions. If supply of output is infinite elastic then supply of inputs must also be infinite elastic (tradable good inputs). Estimation of value of input distortion = Σ iaix

oPimdi where aix

o is the input-output coefficient of the input, i, used to produce a unit of x, while P i

m is the price of a specific input i, and di is the tax wedge associated with the use of input i in the production of x. Step 4Need to adjust for foreign exchange premium (FEP) and premium on non-tradable outlays (NTP) on tradable and non-tradable goods and services, respectively. Total costs of production made up with tradable inputs proportion (Tx) and non-tradable inputs proportion (NTx). In the case of thermal electricity supply we would expect Tx to be close to 1 and NTx to be quite small, where Tx + NTx = 1. Estimation of adjustments for premiums = Px

m Tx FEP + Pxm NTx NTP

To summarize, the economic value of a unit of good x being demanded (or produced) by our project is equal to: Px

m - ΣiaixoPidi + Px

m Tx FEP + Pxm NTx NTP

or, Pxm [1 + (Tx FEP) + (NTx NTP)] - Σiaix

oPi di

Illustrative Example: Estimating the Economic Cost of a Non-tradable Input

• Assume that the market for clay bricks is competitive, the market price is

subject to a 14% excise tax and brick producers receive a 15% subsidy (k) on

their production cost.

• Without the project, the quantity demanded and supplied in the market is 7

million bricks per month at a market price (Pmz) of R0.2 per brick.

• Now introduce a project that requires 300,000 bricks per month.

• Two of the inputs used in the production of bricks have distortions in their

markets: (1) Clay, a non-tradable good, has a 14% excise tax levied on its

market price (Pmclay) of R7 per ton, (2) Furnace oil, an importable good, has a

subsidy (koil) of 20% on its CIF price of US $240 per ton.

• The input-output coefficient for furnace oil (Azoil) is 0.180 tons of oil per 1000

bricks and that of clay (Azclay) is 3.5 tons of clay per 1000 bricks.

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Illustrative Example: Estimating the Economic Cost of a Non-tradable Input (cont’d)

• The tradable, T, (proportion of the market price) and non-tradable, NT,

(proportion of the market price) good components of bricks are

estimated at 0.60 and 0.40, respectively, of the market price of bricks.

• The market exchange rate (Em) is R9.85 per US dollar, the economic

exchange rate (Ee) is R10.44 per dollar, NTP is 1%, and the weighted

average rate of indirect taxes on traded and non-tradable goods and

services (d*) is 9%.

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Prices, Relative Supply and Demand Weights, and Tradable and Non-Tradable Components for Brick Production

Price Estimation

Pmz = R0.2

Psz = Pm

z / (1 - zk) = 0.2 / (0.85) = R0.2353

Pdz = Pm

z (1 + excise tax) = 0.2 (1.14) = R0.2280

• Assigning a weight of 0.67 to the supply side (Wsz) and a weight of 0.33

to the demand side (Wdz) and seems plausible.

• Pe = 0.33 * 0.2280 + 0.67 * 0.2353

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Adjustment for distortions in markets for bricks and where the diverted demand moves :

Pzm [1 + (tz – d*)]

where tz is equal to excise tax, 14%.d* is the weighted average rate of indirect taxes on traded and non-tradable goods and services, 9%.

The net adjustment is: - Pz

m d* = - 0.2 x 0.09 = - 0.0180 R/brick

• On the demand side, the tax on good tz, that other demanders will not be paying because they are now buying other goods is partially offset by the taxes they will now pay d*.

• Hence, the opportunity cost of the forgone consumption of others is equal to,

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Estimating the value of the distortion per ton of furnace oil (Tradable component)

Pimdi = CIF Price Em (-k)

= 240 9.85 (-0.2)

= -R 472.80 per ton

aoilkPimdi (the value of the distortion per brick)

= aoilz* (-472.8/1,000)= - 0.18 *0.4728= - 0.085 R/brick

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Estimating the value of the distortion per ton of Clay

Pmclay * aclayz [Ws

clay(dclay – kclay) + Wdclay d*]

= 7 * 0.0035 [0.67 * (0.14 – 0) + 0.33*0.09]

= 0.0245 (0.0938 + 0.0297)

= 0.0245 (0.1235)

= 0.0030 R/brick

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Estimating the Economic Price of Brick

Pze = Wz

s Pzm/(1-kz) + Wz

d Pzm [1 + (tz – d*)]

- Wzs{Σiaiz

oPmi di + Σjajz

o[WjsPm

j(dj – kj) + WjdPm

j d*]}

+ Pzm Tz FEP + Pz

m NTz NTP

= 0.67 (0.2353) + 0.33 (0.2280 – 0.0180)

- 0.67 (-0.085 + 0.0030) + 0.2 (0.60)(0.06) +0.2 (0.40)(0.01)

= 0.2270 + 0.0549 + 0.0072 + 0.0008

= 0.2899 R/brick

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Conversion Factor for Bricks

• To estimate the commodity specific conversion factor for

bricks used by a project (CSCFdz), we divide the economic

price by the financial demand price.

• Recall that the demand price is inclusive of the excise tax.

CSCFdz = Pe

z / Pdz

= 0.2899/ 0.228

= 1.2715

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Final Good X Subject to VAT or Zero Rated• If final good X is subject to VAT or Zero Rated, then VAT paid on purchase of inputs

can be taken as a credit against tax owed on sale of output or refunded if zero rated when final product is exported.

• The line item in the financial analysis reporting the net VAT payments to the government (or refunds of input taxed received from the government on exports) will have a conversion factor of zero.

• In calculation of conversion factors the financial price of the items include the VAT in the financial values.

Final Good X Exempt from VAT• If the final good X is exempt from the VAT, the value added tax paid on the inputs will

have to be taken into account in deriving the economic value of output because no credit is possible against the tax on the sales of final good, because there is no tax liability.

• The rate of VAT on the price of input i would have to be estimated tvi. The amount of

adjustment to WxsPx

s is - Wxs(AT

xiPim ti

v) for the economic analysis.• This is the identical treatment to the case of any excise tax, sales tax or import tariff on

an input. When these taxes are not used as a credit to offset any indirect taxes owed on the sales of final good or service.

SPECIAL NOTE:

Adjustment for VAT in the Markets of the Inputs Used in the Production of

a Non-Tradable Good

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0 Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Six