Chapter 5

SOCIAL COST BENEFIT ANALYSIS (SCBA)

Introduction
Social Cost Benefit Analysis (SCBA) is a methodology for evaluating investment
projects from the social point of view. In the context of planned economies, SCBA aids in
evaluating individual projects within the planning framework.
According to P.K. Mattoo, “SCBA is the process of evaluating a project from the point of
view of the total impact which the project will have on the economy of the nation.”
According A.R. Prest and R. Turvey, “SCBA is a practical way of assessing the
desirability of projects where it is important to take a long view and a wide view, i.e. it
implies the enumeration and evaluation of all the relevant costs and benefits.”
In fine, we can say that SCBA is a methodology which focuses on social costs and
benefits of a project and is concerned with tactical decision making within the framework
of broad strategic choices defined by planning at the micro level.
Social Cost Benefit Analysis (SCBA) is done for the following principal reasons:
1. Market imperfections;
2. Externalities;
3. Taxes;
4. Concern for redistribution;
5. Concern for savings;
6. Merit wants.

1. Market imperfections:
Market prices, which form the bases for computing the monetary costs and benefits from
the point of view of project sponsor reflect social values only under the conditions of
perfect competition. But in developing countries the conditions of perfect competition are
rarely, if ever, realized. Due to the market imperfect, market prices do not reflect social
values.
In developing countries the following are most common market imperfections:
i. Rationing: Rationing of a commodity means control over its price and distribution.
Under rationing the price paid by a consumer is often significantly less than the price that
would prevail in a competitive market.
ii. Prescription of minimum wage rates: When minimum wage rates are prescribed, the
wages paid to labor are usually more than what the wages would be in a competitive
labor market free from such wage legislations.

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iii. Foreign exchange regulation: The official rate of foreign exchange in most of the
developing countries which exercise close regulations over foreign exchange is typically
less than the rate that would prevail in the absence of foreign exchange regulation.

2. Externalities:
A project may have beneficial external effects. For example, it may create certain
infrastructural facilities like roads, power, water, employment etc. which benefit the
neighboring areas. Such benefits are considered in SCBA, though they are ignored in
assessing the monetary benefits to the project sponsors. Like wise, a project may have a
harmful external effect like environmental pollution. In SCBA the cost of such
environmental pollution is relevant, though the project sponsors do not incur any
monetary costs.

3. Taxes and Subsidies:

From the private point of view taxes are definite monetary costs and subsidies are definite
monetary gains. From the social point of view, however, taxes and subsidies are generally
regarded as transfer payments, and hence considered irrelevant.

4. Concern for Savings:

For being unconcerned, a private firm does not divide its benefits between consumption
and savings. From a social point of view, however, the division of benefits between
consumption and savings (which leads to investment) is relevant, particularly in capital
scarce developing countries. The concern of society for savings and investment is duly
reflected in SCBA wherein a higher valuation is placed on savings and lower valuation is
put on consumption.

5. Concern for Redistribution:

A private firm does not bother how its benefits are distributed across various groups in
the society. The society, however, is concerned about the distribution of benefits across
different groups. A taka of benefit going to a poor section is considered more valuable
than a taka of benefit going to an affluent section.

6. Merit Wants:
Goals and preferences not expressed in the market place, but believed by policy markers
to be important in the larger social interest may be referred to as merit wants. For
example, the government may prefer to promote adult education or a balanced nutrition
program for school going children even though these are not sought by consumers in the
market place. While merit wants are not relevant from the private point of view, they are
important from the social point of view.
APPROACHES FOR SCBA

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Towards the end of the sixties and in the early seventies two principal approaches for
SCBA emerged:

a. UNIDO approach; and

b. Ian M. D. Little- James A Mirrlees approach

A. UNIDO (United Nations Industrial Development Organization) approach

In 1972, the UNIDO approach was first articulated in the UN publication 'The Guidelines
for Project Evaluation.' In 1978, the UNIDO of the UN published 'Guide to Practical
Project Appraisal' which provides a comprehensive framework for SCBA in developing
countries. This method of project appraisal involves five stages:
1. Calculation of financial profitability of the project measured at market prices.
2. Obtaining the net profit of the project in terms of economic prices.
3. Adjustment for the impact of the project on savings and investment.
4. Adjustment for the impact of the project on income distribution
5. Adjustment for the impact of the project on merit goods and demerit goods.

Each stage of appraisal is chronologically discussed below:

1. Financial profitability at market prices:

This stage seeks to ascertain whether the proposed project will be financially viable in the
sense of being able to meet the burden of servicing debt and whether the proposed project
will satisfy the return expectations of those who provide capital. In calculating financial
profitability the following aspects should be taken into account:
(a) Investment out lay and cost of project; (b) Means of financing (c) Cost of capital; (d)
Projected profitability; (e) Break-even point; (f) cash flow of the project; (g) level of risk
etc.

2. Net benefit in terms of shadow prices:

Stage two of he UNIDO approach is concerned with the determination of net benefit of
the project in terms of economic (efficiency) prices, also referred to as shadow prices.
Market prices represent shadow prices only under conditions of perfect market which are
rarely, if ever, realised by developing countries. Hence, there is a need for developing
shadow prices and measuring net economic benefit in terms of these prices.

Shadow Pricing: Basic Issues

The shadow price of a traded good is simply its border price. If a good is exported, its
shadow price is its FOB (Free on Board) price and if a good is imported its shadow price
is its CIF (Cost Insurance and Freight) Price. The shadow prices for non-traded items are
defined in terms of marginal social cost and marginal social benefit.

Basic concept and issues of shadow pricing

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i. Choice of Numeraire: One of the important aspects of shadow pricing is the
determination of the numeraire, the unit of account in which the value of inputs or
outputs is expressed.
The UNIDO approach uses domestic currency as numeraire. To define numeraire some
questions relating to the unit, value and time for measuring costs and benefits have to be
answered.

ii. Concept of Tradability: A key issue in shadow pricing is whether a good is tradable or
not. A product is called tradable product if it can be exported or imported without any
exchange barrier. On the other hand, a product is called non-tradable if the price of a
product is higher than the FOB or less than the CIF (Cost, Insurance and Freight). For a
good that is tradable, the international price is a measure of its opportunity cost to the
country. Because, for a tradable good, it is possible to substitute import for domestic
production and export for domestic consumption and vice-versa.

iii. Sources of Shadow Prices: The UNIDO approach suggests that a project may have
the following three impacts on its economy:
(a) Increase or decrease of the total consumption in the economy.
(b) Increase or decrease of production in the economy.
(c) Increase/decrease of imports or increase/decrease of exports.
Considering the impacts of a project on the national economy the UNIDO approach
suggests the following sources of shadow prices:
a. If the project leads to an increase or decrease of the total consumption in the
economy, the basis of shadow price will be the consumers' willingness to pay.
b. If the project leads to an increase or decrease of the total production in the
economy the basis of shadow price will be the production cost.
c. If the project leads to an increase/decrease of imports or increase/decrease of
exports the basis of shadow price will be the Foreign exchange value.
Consumer Willingness to Pay: If the impact of the project is on the consumption in the
economy, the basis of shadow pricing is consumer willingness to pay. The measurement
of consumer willingness to pay may be explained with the help of the following figure:

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Price
In the graph shown in this figure
DD = Demand schedule
S SS = Supply schedule
D
E = Equilibrium point
QQ Quantity bought
E
OP = Price paid per unit
P

S
D

O Q Quantity

Figure: Consumer willingness to pay

Looking at the demand schedule we find that the consumer who buys the first unit is
willing to pay price OD for that unit and the consumer who buys the last unit is willing to
pay price OP for that unit. The consumer willingness to pay for various units is indicated
by the schedule DE. So, the total willingness to pay by consumers who buy the product is
measured by the area ODEQ. The price paid by them, however, is only OPEQ. The
difference between ODEQ and OPEQ, namely DEP, is referred to as the consumer
surplus.

3. Measurement of the impact on savings and investment

Most of the developing countries face scarcity of capital. Hence, the governments of
these countries are concerned about the impact of a project on savings and its value there
of. Stage three of the UNIDO method, concerned with this, seeks to answer the following
questions:
 Given the income distribution impact of the project what would be its effect on
savings?
 What is the value of such savings to the society?

Value of savings
The value of one taka of savings is the present value of the additional consumption
stream produced when that taka of savings is invested at the margin. The additional
consumption stream produced from the investment of one taka depends on two things:
a. The marginal productivity of capital; and
b. The rate of re-investment from the additional income.

4. Measurement of the impact of distribution:

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Stage four of the UNIDO method is concerned with measuring the impact of the project
on income distribution. In assessing the viability of a project from the view point of
SCBA under the UNIDO method relative weight is given on the distribution of the
income among different groups of the society. This calls for suitably weighting the net
gain or loss to various groups in the society and summing them.

5. Adjustment for merit and demerit goods:

In some cases the analysis has to be extended beyond stage four to reflect the difference
between the economic value and social value of resources. This difference exists in the
case of merit goods and demerit goods. A merit good is one for which the social value
exceeds the economic value. For example, a country may place a higher social value than
economic value on production of oil because it reduces dependence on foreign supplies.
In the case of demerit good, the social value of the good is less than its economic value.
For example, a country may regard alcoholic products having social value less than
economic value.
The procedure for adjusting for the difference between social value and economic value
is as follows:
(i) Estimate the economic value;
(ii) Calculate the adjustment factor as difference between the ratio of social value
to economic value and unity;
(iii) Multiply the economic value by the adjustment factor to obtain the
adjustment;
(iv) Add the adjustment to the net present value of the project.

B. Little-Mirrlees (L-M) Approaches

I.M.D Little and J.A Mirrlees have developed this approach.

There is considerable similarities / similarity between the UNIDO approach and the L-M
approach. Both the approaches call for:
(1) Calculating accounting (shadow) prices particularly for foreign exchange, savings
and unskilled labor,
(2) Considering the factor of equity; and
(3) Use of DCF (Discount Cash Flow) analysis.

Despite considerable similarities there are certain differences between the two
approaches:
UNIDO approach L-M approach
(1) The UNIDO approach measures costs (1) The L-M approach measures costs and
and benefits in terms of domestic prices. benefits in terms of international prices,

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(2) This approach measures costs and
benefits in terms of consumption.
(3) This approach considers matters
relating to efficiency, savings, and
redistribution stage by stage.
also referred to as border prices.
(2) This approach measures costs and
benefits in terms of uncommitted social
income.
(3) This approach tends to view these
considerations together.