Dev 567 Project and Program Analysis Lectures 6 & 7: Economic Appraisal of Projects

Dev 567Project and Program Analysis

Lectures 6 & 7: Economic Appraisal of Projects

Dr. M. Fouzul Kabir KhanProfessor of Economics and Finance

North South University

• 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

Lecture 6

Analyzing Economic Costs and Benefits in an Existing Market

Price in Rand/Unit Price in Rand/Unit

Units of Output Units of Output

Pmax Pmax

Pm

0 Qm

C Pm

Qm 0

C

Demand

Supply

E

(a) Total Economic Benefit (b) Total Economic Cost

Units of Output

Price in Rand/Unit

Pmax

Pm C

0 Qm

Demand

Supply

E

(c) Total Economic Benefits and Costs

Producer surplus

Consumer surplus

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 Economic Costs and Benefits in an Existing Market

Valuing Project outputs Will depend on the nature of the market in which the

output is traded.

Elastic demand, or a small project Use market price Quantity supplied by the project *market price

Perfectly inelastic supply 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



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

• 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 (Cont’d)

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

)(*2

'21 qqPP

)(*2

'2 qqPPres

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

Economic Cost of an Input Demanded by a Project in an Undistorted Market: Inelastic supply


Economic Cost of an Input Demanded by a Project in an Undistorted Market: Upward sloping supply curve and a large 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

Analyzing the Economic Cost of an Input (subject to tax) Demanded by a Project

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?

Class Exercise

Analyzing the Economic Cost of an Input (subject to taxes related to externalities)

Demanded by a Project

• 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.

Economic Evaluation of Non-Tradable Goods and Services 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.



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





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


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


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

Benefits and Cost of Traded Goods and Services

Economic Prices of Traded Goods and Services

Economic Prices of Traded Goods and Services

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

Valuing Impacts from Observed Behavior

• 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

Demonstrations

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.

Direct Estimation of Demand Curves

• 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

Exercise

pq 10 Linear demand curve

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

Using a Slope Estimate

Social Surplus Gain from Refuse Fee

• 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.

Using an Elasticity Estimate

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

Extrapolation and Econometric Estimation

• 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


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 I

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.

Exercise II

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 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

Intermediate Good and Asset Valuation 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

Travel Cost Method

• Shadow prices• Project analysis in developing countries• LMST accounting price method in practice• Intermediate goods and asset valuation

method• Travel cost method• Social discount rate

Lecture 8

• When a market does not exist or market failure

leads to a divergence between market price and

marginal social cost, analysts try to obtain

estimates of what market price would be if the

relevant good were traded in a perfect market.

Such an estimate is called a shadow price

• Estimates of shadow prices when markets are

missing– Examples: value of a unit of time, statistical life, or the

(negative) value of a particular type of crime

Shadow Prices

Shadow Prices

Shadow Prices

Plug-Ins for Value of Travel Time Saved

Shadow Prices

Plug-Ins for Value of Recreational Activities (in 1999 U.S. dollars)

Shadow Prices

Plug-Ins for Value of Environmental Impact (in 1999 U.S. dollars)

Shadow Prices

Project Analysis in developing countries have much in common with Project Analysis in industrialized countries

The main distinguishing characteristic of Project Analysis in developing countries is the much grater emphasis on adjusting the market prices of project output and inputs so that they more accurately reflect their value to society◦ Markets are more distorted in developing countries

Segmented labor market Overvalued exchange rate Tariffs, taxes, and import controls Formal and informal credit markets

◦ Use shadow prices/accounting prices instead of market prices

Project Analysis in Developing Countries

Developed by UNIDO, I.M.D Little and J.A. Mirrlees, synthesized by Lynn Squire and Herman G. van der Tak

The LMST methodology◦ Use world prices as shadow price for all project inputs

and outputs that are classified as tradable◦ World prices are less distorted than domestic prices

Imported input valued at import price, CIF Exported output valued at export price, FOB

Examples◦ Steel plant◦ Agricultural crop

LMST Accounting Price Method

• Shadow pricing involves multiplying each market price by an accounting price ratio – APR for good i = accounting/shadow price of good i

/market price of good i– Shadow price of good i = APR of good i *market price

of good i– Small country assumption

• Shadow price of an imported input or an output that is an import substitute

• Shadow price of an export• Shadow price of a non-tradable good (electricity)

LMST Method in Practice

• CIF price * Exchange rate = World Price in domestic currency– Use shadow exchange rate, if there is a big

difference between official and market exchange rates

• Accounting prices– CIF price: APR = 1– Tariff : APR = 0– Transport cost: APR = 0.5–Distribution cost: APR = 0.8–Weighted APR: 0.85

• Shadow price= Market Price*APR

Accounting Price of an Import

Item Dollar Price

Market Price(Tk)

APR Accounting Price

CIF Price 40 2800 1.00 2800

Tariff - 350 0.00 -

Transport - 280 0.50 140

Distribution - 175 0.80 140

Total 3605 0.85 3080

Accounting Price of an Imported Good

• FOB Price• Export tax is a transfer between foreign

purchaser (no standing) and the government: APR= 1

• Transport for export: APR= 0.5• Factory gate price: APR=1• Shadow price = 5180*1+70*0.5+1750*1=Tk. 6965

Accounting Price of an Export

Item Dollar Price

Market Price(Tk)

APR Accounting Price

FOB Price 100 7000 - -

Export tax 25 1750 1.0 1750

Transport 1 70 0.5 35

FactoryGate

74 5180 1.0 5180

Transport(d) - 120 0.5 60

Distribution(d) - 300 0.8 240

Accounting Price for Export

• LMST involves determining the equivalent value of non-tradables in world prices

• Breaking down the cost of inputs into traded, non-traded and labor components

• Multiply market price by applicable accounting price ratio– CIF prices: APR =1–Domestic transfer (tariffs and taxes): APR = 0– Labor: APR = 0.6– Standard conversion factor: 0.80

Accounting Price of Non-tradable

Accounting Price for Electricity Valued or Marginal Cost of Supply (in thousands of pesos)

Semi-input-output analysis Consumption conversion factors

Weighted average of accounting price ratios for a

nationally representative market basket of goods

Standard conversion factors

SCF = (M+X)/[(M+ Tm –Sm)+(X-Tx+Sx)]

Where M= Total value of imports(CIF)

X = Total value of exports(FOB)

Tm = Total tariff on imports

Tx = Total taxes on exports

Sm = Total subsidies on imports

Sx = Total subsidies on exports

Average value of SCF for different countries 0.8

(ranges between 0.59-0.96)

Conversion factors

Constant marginal costs up to capacity level, up to Q1 and then completely

inelastic Whether the fixed supply is binding or not If not binding (demand with the project within the elastic range), no change

in market price. Would not affect the current consumers of electricity◦ Would require additional input to produce additional electricity, use

shadow cost method for non-tradables If binding, (demand with the project is in the inelastic range), market price

will increase. Current consumers lose surplus and producers gain surplus Measured in market prices, the cost of electricity would equal [(P1+P2)/2]

(Q1-Q2) To convert into shadow price equivalent, multiply the cost by the

consumption conversion factor( weighted average of accounting price ratios for a nationally representative market basket of goods).

Shadow Pricing when Goods are in Fixed Supply

Shadow Pricing when Electricity is Completely Elastic and Inelastic

Location of the project Source of labor Accounting price ratio of type j labor = Shadow

price of type j labor/ the market wage for type j labor

Shadow price of foreign workers◦ SWf = [h + (1-h)(CCF)](PW)

◦ Where PW is the project wage, h is the fraction of PW sent or taken home, and 1-h is the fraction spent domestically

Rural market wage◦ RMW = 0.5($50) + 0.25($10) + 0.25($.15) = Tk. 31.25

The Shadow Price of Labor

• How much current consumption society is willing to give up now in order to obtain a given increase in future Consumption?

• It is generally accepted that society’s choices, including the choice of weights be based on individuals’ choices

• Three unresolved issues– Whether market interest rates can be used to represent how individuals

weigh future consumption relative to present consumption?

– Whether to include unborn future generation in addition to individuals alive today?

– Whether society attaches the same value to a unit of investment as to a unit of consumption

• Different assumptions will lead to choice of different discount rate

The Social Discount Rate: Main Issues

Generally a low discount rate favors projects with

highest total benefits, irrespective of when they

occur, e.g. project C Increasing the discount rate applies smaller

weights to benefits or (costs) that occur further in

the future and, therefore, weakens the case for

projects with benefit that are back-end loaded

(such as project C), strengthens the case for

projects with benefit that are front-end loaded

(such as project B).

Does the Choice of Discount Rate Matter?

Year Project A Project B Project C

0 -80,000 -80,000 -80,000

1 25,000 80,000 0

2 25,000 10,000 0

3 25,000 10,000 0

4 25,000 10,000 0

5 25,000 10,000 140,000

Total benefits 45,000 40,000 60,000

NPV (i=2%) 37,838 35,762 46,802

NPV (i=10%) 14,770 21,544 6,929

NPV for Three Alternative Projects

Appropriate Social Discount Rate in Perfect Markets

● As individuals, we prefer to consume immediate benefits to ones occurring in the future (marginal rate of time preference)

● We also face an opportunity cost of forgone interest when we spend money today rather than invest them for future use (marginal rate of return on private investment)

● In a perfectly competitive market:

rate of return on private investment = the market interest rates = marginal rate of time preference (MRTP)

● The rate at which an individual makes marginal trade-offs is called an individuals MRTP

Therefore, we may use the market interest rate as the social

discount rate

Equality of MRTP and Market Interest Rate

Alternative Social Discount Rate in Imperfect Markets

•Six potential discounting methods– Social discount rate equal to marginal rate of return on

private investment, rz

– Social discount rate equal to marginal rate of time preference, pz

– Social discount rate equal to weighted average of pz, rz

and i , where i is the government’s real long-term borrowing rate

– Social discount rate is the shadow price of capital– A discount rate that declines over the time horizon of

the project– A discount rate SG, based on the growth in real per

capita consumption


Using the marginal rate of return on private investment◦ The government takes resources out of the private sector◦ Society must receive a higher rate of return compared to the

return in the private sectorCriticism

◦ Too high Return on private sector investment incorporates a risk premium

◦ Government project might be financed by taxes, displaces consumption rather than investment

◦ Project may be financed by low cost foreign loans◦ Private sector return may be high because of monopoly or

negative externalities◦ Government investment sometimes raises the private return

on capital


Using the marginal social rate of time preference, pz

◦ Numerical values of pz

Real after-tax return on savings, around 2 percent for the US economyCriticisms

◦ Individuals have different MRTP◦ How to aggregate such individual MRTP◦ Market interest rate reflects MRTP of individuals currently alive

Using the weighted social opportunity cost of capitalWSOC= arz + bi + (1-a-b)pz

◦ Numerical Value, 3 percent for the US economy

Social discount rate should be obtained by weighting rz and pz

by the relative size of the relative contributions that

investment and consumption would make toward funding the

project

s = arz + (1-a)pz,

where a = ΔI/(ΔI+ ΔC) and (1-a) = ΔC/(ΔI+ ΔC) Savings are not very responsive to changes in the interest

rate, ΔC is close to zero The value of the parameter a is close to one

The marginal rate of return on private investment rz is a good

approximation of true social discount rate

Harberger’s Social Discount Rate


Criticisms of WSOCCriticisms applicable to use of rz and pz appliesDifferent discount rates for different projects based on source

of financingUse the shadow price of capital

Strong theoretical appealDiscounting be done in four steps

Costs and benefits in each period are divided into those that directly affect consumption and those affect investment

Flows into and out of investment are multiplied by the shadow price of capital θ, to convert them into consumption equivalents

Changes in consumption are added to changes in consumption equivalents

Discounting the resultant flow by pz

)1(r

)1)((r

z

z

ffp

f

z


• Shadow price of capital

Where rz is the net return on capital after depreciation, δ is the depreciation rate of capital, f is the fraction of gross return that is reinvested, and pz is the marginal social rate of time preference

– Numerical values for the θ,SPC, 1.5-2.5 for the US economy

– Applying SPC in practice• Criticism of calculation and use of the SPC


Using time-declining discount rates Conclusion, social discounting in imperfect markets

◦ If all costs and benefits are measured as increments to consumption, use MSRTP, pz, Boardman et. Al. suggests a value of

2 percent, sensitivity 0-4 percent◦ If all costs and benefits are measured as increments to private

sector investment, use MRROI, rz, Boardman et. Al. suggests a

value of 8 percent, sensitivity 6-10 percent◦ If all costs and benefits are measured as increments to both

consumption and private sector investment, use SPOC, θ, to

increments in investment and then discount at MSRTP, Boardman et. Al. suggests for SPOC, a value of 1.65 percent, sensitivity 1.3-2.7 percent; and ΔI = 15 percent and, ΔC= 85 percent, in the absence of information

The Social Discount Rate in Practice

Many government agencies do not discount at all

Shadow price of capital is rarely used

Governments do not use time-varying discount rates

Constant positive rate that varies from country to country

◦ US, 7-10 percent

◦ Canada, 10 percent, sensitivity 5-15 percent

◦ 0-3 percent for Health and Environment Projects

ADB, EIRR of 10-12 percent

Zone

Travel Time

(hours)

Travel Distanc

e(km)

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)

A 0.5 2 20 15 525 5,250 150

B 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

Total 10,800 440

Illustration of the Travel Cost Method

Travel Cost Method

Documents

Dev 567 Project and Program Analysis Lectures 6 & 7: Economic Appraisal of Projects