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ANALYSIS
CHAPTER 14
OUTLINE
• Rationale for SCBA
• UNIDO approach
• Net benefit in terms of economic (efficiency) prices
• Savings impact and its value
• Income distribution impact
• Adjustment for merit and demerit goods
• Little-Mirrlees approach
• Shadow prices
• SCBA by financial institutions
• Public sector investment decisions in India
Rationale for SCBA
In SCBA the focus is on the social costs and benefits of the project.
These often tend to differ from the monetary costs and benefits of the
project. The principal sources of discrepancy are:
• Market imperfections
• Externalities
• Taxes and subsidies
• Concern for savings
• Concern for redistribution
• Merit wants
Rationale for SCBA
• Market Imperfections:
Market prices, the basis for CBA, do not reflect the social values under
imperfect market competition.
• Externalities:
A project may have beneficial or harmful external effects that are considered in
SCBA, not in CBA.
• Taxes & Subsidies:
From the social point of view, taxes & subsidies are nothing but transfer
payments. But in CBA, taxes & subsidies are treated as monetary costs and
benefits respectively
Rationale for SCBA
• Concern for Savings:
In SCBA, the division between benefits & consumption is relevant wherein
higher valuation is placed on savings. But in CBA such division is irrelevant.
• Concern for Redistribution:
In SCBA, the distribution of benefits is very much concerning issue where
commercial private firm does not bother about it.
• Merit Wants:
Merit wants are important from the social point of view and therefore, SCBA
considers these wants
SCBA - Approaches
There are two approaches for assessing Social Cost Benefit Analysis
1. UNIDO Approach
This approach is mainly based on the publication of UNIDO (United Nation
Industrial Development Organization) named Guide to Practical Project
Appraisal in 1978.
2. Little-Mirrlees Approach
I.M.D Little & J.A.Mirlees have developed this approach for analysis of Social
Cost-Benefit in Manual of Industrial Project Analysis in Developing Countries
and Project Appraisal & Planning for Developing Countries.
UNIDO Approach
UNIDO Approach
• The UNIDO method of project appraisal involves five stages:
1.Calculation of the financial profitability of the project measured at market prices.
2.Obtaining the net benefit of the project measured in terms of economic (efficiency)
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 whose
social values differ from their economic values.
• Each stage of appraisal measures the desirability of the project from a
different angle.
Stage-1: Calculation of financial profitability
of the project
A good technical and financial analysis must be done before a
meaningful economic (social) evaluation can be made so as to determine
financial profitability.
Financial profitability is indicated by the Net Present Value (NPV) of
the project, which is measured by taking into account inputs (costs) and
outputs (benefits) at market price.
This is similar to financial evaluation discussed previously. Remember
HPC case.
Stage-2: Net Benefits in Terms of Economic
(Efficiency) Prices
• Net Benefits in Terms of Economic (Efficiency) Prices also called as
shadow prices. Market prices represent shadow prices only under
conditions of perfect markets. Developing countries perfect market
conditions are often not fulfilled.
• Therefore, there is a need to develop shadow prices for inputs and
output to measure economic/social benefit of the project.
• Shadow Prices reflect the real value of a resource (input or output) to
society.
Stage-2: Net Benefits in Terms of Economic
(Efficiency) Prices
• Shadow Prices can be defined as the value of the contribution to the
country’s basic socio-economic objectives made by any marginal
change in the availability of commodities (output) or factor of
production (input).
• Shadow Pricing : Basic Issues
• Choice of numeraire
• Concept of tradability
• Source of shadow prices
• Taxes
• Consumer willingness to pay
Shadow Pricing : Basic Issues
• Numeraire
• A unit of account in which the values of inputs and outputs are to be
expressed.
• Specification of Numeraire is at:
• Domestic currency rather than foreign currency.
• Present value rather than future value.
• Constant price rather than current price.
• Tradability
• If good is internationally tradable then International price (border price)
represent real value of good in terms of economic efficiency.
Shadow Pricing : Basic Issues
• Sources of Shadow Pricing:
• Depending on the impact of the project on national economy, there are three
sources of shadow pricing:
Shadow Price
1. Taking labour away from Willingness to pay of other users for this labor
other Employments
2. Induce the new workers 1. Opportunity cost of previous employment = 0 but The value assigned by
the worker on the leisure that he has to forego.
2. The additional consumption of food, the cost of transport
3. the cost of training
4. the cost of urbanization
3. Importing workers Flighting of foreign currency equivalent to the wages commanded by them
along with a premium on account of the foreign exchange.
Shadow Pricing of Specific Resources
• Capital Input:
• Investment of capital in a project causes to happen two things:
1. Financial resources are converted into physical assets
2. Financial resources are withdrawn from national pool of savings. Thus
alternative projects are foregone and there is an opportunity cost of it.
• The shadow price of physical assets is calculated in the same manner
in which inputs and outputs are calculated.
• The opportunity cost of capital (shadow price of capital) depends on
the source from which the capital has generated.
Shadow Pricing of Specific Resources
Generation from additional savings Consumption rate of interest or social discount rate
(the price must be paid to the saver to sacrifice
present consumption)
Generation from the denial of capital to alternatives Investment rate of interest (Investment rate of return
Projects that would be earned from those alternative projects)
Example
• Presently, a ferry service, operated privately, is being used to cross a river. The ferry operator
charges Rs.3 per person. It costs him Rs.2 per person. 50,000 persons use the ferry service. (This
means that the number of persons crossing the river by ferry service throughout the year is 50,000)
• The government is considering construction of a bridge over the river. It is estimated that after the
bridge is constructed 2,50,000 persons will cross the river on the bridge. The bridge is expected to
cost Rs 3 million initially and its annual maintenance cost would be Rs 10,000. It has an
indefinitely long life. Once the bridge is constructed the ferry operator is expected to close down
the ferry service and sell the ferry boats for Rs.100,000.
• Required : Define the social costs and benefits of constructing the bridge, assuming that the
monetary figures given in the problem represent economic values.
Solution :
The social costs and benefits of bridge construction may be defined as
follows:
Costs:
• Project
• Other private business
Measurement of the Impact on Distribution
• Government
• Workers
• Consumers
• External sector
• The gain or loss to an individual group within the society as a result of the
project is equal to the difference between the shadow price and the market
price of each input or output in the case of physical resources or the
difference between the price paid and the value received in the case of
financial transactions.
Measurement of the Impact on Distribution
• Example:
• Farmers in a certain area use 1 million units of electricity generated by a
hydroelectric project. The benefit derived by them, measured in terms of the
willingness to pay, is equal to Rs.0.4 million. The tariff paid by them to
electricity board is Rs. 0.25 million. So the impact of project on farmers is 15
million.
Savings Impact and its Value
• 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 thereof. 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?
Impact on Savings
The savings impact of a project is equal to:
i MPSi
Where i = change in income of group i as a result of the project
MPSi = marginal propensity to save of group I
Example:
As a result of a project the income gained /lost by four groups is:
Group 1 = Rs. 100,000
Group 2 = Rs 500,000,
Group 3 = -Rs.200,000 and Group 4 = -Rs 400,000.
Impact on Savings
The marginal propensity to save of these four groups is as follows:
MPS1 = 0.05, MPS2 = 0.10, MPS3 = 0.20, and MPS4 = 0.40
Example:
• Present economic value of the project is Rs. 25 million up to stage IV. The output of the
project has a social value which exceeds its economic value by 20%.
• Then Adjustment factor is .2 (120/100 -1).
• Multiply Present Economic Value by this Adjustment factor (25x.2= 5 million).
• The total value of the project after this adjustment = 25 + 5 = Rs. 30 million.
Little-Mirrlees Approach
Little-Mirrlees Approach
• I.M.D. Little and James A. Mirrlees have developed an approach to
SCBA which is famously known as L-M approach.
• The core of this approach is that the social cost of using a resource in
developing countries differs widely from the price paid for it.
• Hence, it requires Shadow Prices to denote the real value of a resource
to society.
Little-Mirrlees Approach
There is considerable 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 labour.
2. Considering the factor of equity
3. Use of DCF analysis
Little-Mirrlees Approach
Despite considerable similarities there are certain differences between the two
approaches:
1. The UNIDO approach measures costs and benefits in terms of domestic rupees whereas the
L-M approach measures costs and benefits in terms of international prices, also referred to
as border prices.
2. The UNIDO approach measures costs and benefits in terms of consumption whereas the L-
M approach measures costs and benefits in terms of uncommitted social income.
3. The stage-by-stage analysis recommended by the UNIDO approach focuses on efficiency,
savings, and redistribution considerations in different stages.
4. The L-M approach, however, tends to view these considerations together.
1. Labour
2. Traded Goods
3. Non-traded Goods
• The data required for calculating the ERP may be arranged as follows:
At domestic prices At world prices
A. Selling price
B. Input cost:
Traded
Non-traded
C. Value added
Domestic Resources Cost
• Domestic resources cost (DRC) reflects the domestic cost incurred per unit of foreign exchange
saved or earned. Financial institutions use the following formula to calculate DRC
A+B+C
DRC = x Exchange rate
P – (Q + R + S + T)
Where
A = annual charge on domestic capital calculated at the rate of 10 percent.
B = annual depreciation on domestic capital assets (other than land) calculated at the rate of 8 percent
C = annual cost of non-traded inputs
P = sales realisation at international prices
Q = annual charge on imported capital assets at the rate of 10percent
R = annual depreciation on imported capital assets at the rate of 8 percent
S = annual cost of imported inputs
T = annual cost of domestically procured, but tradable inputs
Public Sector Investment Decisions in India
Very broadly the principal steps in the public investment decision making process in India are as
follows:
1. The Planning Commission formulates the five-year plan indicating the broad strategy of planning,
the role of each sector, the physical targets to be achieved by each sector, and the financial outlays
to be made available for the development of each sector.
2. The administrative ministries develop sectoral plans. It is in these plans that the projects of the
public sector enterprises are identified. The identification of a project provides the green signal for
the preparation of its feasibility report.
3. The concerned public sector enterprise prepares the feasibility report and forwards it to its
administrative ministry.
4. The administrative ministry carries out a preliminary scrutiny of the feasibility report and sends
copies of the same to the various appraising agencies, namely, the Planning Commission, the
Department of Economic Affairs and the Plan Finance Division of the Finance Ministry, and the
Bureau of Public Enterprises for their comments.
Public Sector Investment Decisions in India
5. The Project Appraisal Division (PAD) of the Planning Commission carries out a detailed appraisal.
The objective of its appraisal is not only to suggest whether to accept or reject the project but also
to suggest how it may be re-formulated to enhance its technical, financial, commercial, and
economic viability.
6. The Investment Planning Committee of the Planning Commission discusses the appraisal note of
the PAD and recommends to the PIB the view of the Planning Commission on whether the project
should be accepted, rejected, deferred, reformulated, or redesigned.
7. The PIB considers the (a) appraisal note of the PAD along with the view of the planning
Commission, (b) the comments of the BPE, (c) the comments of the plan finance division of the
ministry of finance, and (d) the note of the administrative ministry. If the PIB clears the project, it
sends it to the cabinet for its approval
8. The cabinet generally accepts the recommendation of the PIB and approves its implementation.
SUMMARY
• In SCBA the focus is on social costs and benefits of a project. These often tend to differ from the
costs incurred in monetary terms and benefits earned in monetary terms by the project. The
principal reasons for discrepancy are: (i) market imperfections, (ii) externalities, (iii) taxes, (iv)
concern for savings, (v) concern for redistribution, and (iv) merit and demerit goods
• Towards the end of the sixties and early seventies two principal approaches for SCBA emerged :
UNIDO approach and Little- Mirrlees approach.
• The UNIDO method of project appraisal involves five stages: (i) calculation of the financial
profitability of the project measured at market prices; (ii) obtaining the net benefit of the project
measured in terms of economic (efficiency) prices; (iii) adjustment for the impact of the project on
savings and investment; (iv) adjustment for the impact of the project on income redistribution; and
(v) adjustment for the impact of the project on merit and demerit goods.
SUMMARY
• As per the L-M approach, the outputs and inputs of a project are classified into the following
categories: (i) traded goods and services, (ii) non-traded goods and services, and (iii) labour.
• The shadow price of a traded good is simply its border price. If a good is exported its shadow price
is its FOB price and if a good is imported its shadow price is its CIF price. The shadow prices for
non-traded items are defined in terms of marginal social cost and marginal social benefit.
• The L-M approach suggests the following formula for calculating the shadow wage rate (SWR)
SWR = c’ – 1/s (c-m)
• While the all-India term-lending institutions – IDBI, IFCI, and ICICI- approach project proposals
primarily from the financial point of view, they also evaluate them from the larger social point of
view.
• Though there are some minor variations, the three institutions follow essentially a similar approach
which is a simplified version of the L-M approach.
SUMMARY
• IDBI, the apex term-lending financial institutions, considers three aspects in its economic appraisal
of industrial projects: economic rate of return, effective rate of protection, and domestic resource
cost
• The economic rate of return is simply the internal rate of return of the stream of social costs and
benefits.
• The effective rate of protection is calculated as follows: Value added at domestic prices - Value
added at world prices Value added at world prices.
• Till the middle of the sixties the mechanism for appraisal and selection of public sector projects
was rather primitive. To improve the quality of project planning and strengthen the public
investment decision making process several steps were taken: creation of the Bureau of Public
Enterprises; establishment of the Project Appraisal Division (PAD) in the Planning Commission;
and institution of the Public Investment Board (PIB).