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CHAPTER THREE
ECONOMIC ANALYSIS OF PROJECTS
4.1. An overview of Economic Analysis
• Economic analysis is one step forward in the project planning effort which
ascertains the overall country impact of a project
• It is a form of more general tool of cost benefit analysis for the society, as
compared to financial analysis, which should assess the impact of a project on
the income of its owners,
• Regardless of their difference, financial analysis is the base for economic
analysis which provides the necessary information to be used.
• Economic analysis is less likely to be needed when the project is small, unless it
is a pilot project to be replicated.
• In economic analysis, the most important question is whether the project under
study is a beneficial to the national economy.
• Once the financial and economic analysis are made for the project worthwhile,
it should be put into action that the projects should be implemented.
• Therefore, the exercise of project appraisal is not accomplished till the proposed
project is also viewed from the economy viewpoint.
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4.1.1 Objectives of Economic Analysis
• The purpose of economic analysis is to ensure that public investment funds are
used only for economically viable projects
• Thus the following main objectives economic analysis are to:
– make evaluation and ascertain the overall country impact of a project
– measure the costs and benefits of a project to the society.
– substitute shadow price or economic prices for market prices because
market prices do not reflect the true prices of scarcity resources.
• Economic analysis to achieve its intended purposes should follow the
following steps.
Step 1: Identify and eliminate transfer payments. Transfer payments
like duties, and taxes should be eliminated and turning the
economic analysis.
Step 2: Identify linkages and externalities
Step 3: Identify the effect on the use or creation of traded goods
Step 4: Identify the effect of the project on the employment of labor
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4.1.2 Economic Significance of Projects
Many projects have an economic and/or national significance especially if
they are in:
– the area of hi-tech,
– import substitution,
– export orientation,
– defense and/or
– involve substantive outflow of foreign currency either for
technology know-how or for raw materials.
It is necessary to evaluate the national significance of a project is to be made
acceptable in the prevalent economic scenario.
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Under employment: In developing countries like Ethiopia, the domestic prices are
distorted and do not reflect the real value of inputs and outputs. One of the highly
distorted market is the labor market.
• For instance, unskilled and semi-skilled labor market is highly affected because
workers are paid less and the payment is not the same for all doing the same job.
Income/wealth inequality: Due to this inequality, price may not reflect the social
equalities.
• As a result, project analysts shift to apply social pricing techniques that is
shadow pricing techniques.
Externalities: costs and benefits of externalities as a whole are attributed to the
project not taken into account in estimating values for the project inputs and outputs
and need to be excluded from the economic analysis.
Tariffs, customs and duties: these restrictions and impositions by the government
may increase the price of commodities and need to be excluded from the economic
analysis because they does not reflect the commitment of real resources.
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Remarks,
 Since the existence of the above mentioned factors in economic
analysis, the value of inputs and outputs of a project cannot reflect its
real value.
 All the markets such as commodity, labor, foreign exchange and capital
markets are highly distorted in developing countries.
 Therefore, these distortions should be adjusted as the market prices and
economic prices are not the same and for the prices to reflect the real
cost of resources, we use shadow prices.
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4.2 Identification of Cost and Benefits of Economic Analysis
• Basically, the procedures followed and the criteria used such as NPV, IRR,
BCR and others are the same, but their values are different in economic and
financial analysis of projects.
• The main factors which explain these difference, are:
• The items considered as inputs and outputs of the project;
• The prices used in the valuation of inputs and output and
• The treatment of taxes, subsidies and other transfer payments.
• The items considered as inputs and outputs of the project: Some real costs
and benefits attributed to projects are considered as “external” to the enterprise
but viewed as “internal” when they are considered from the economy’s angle.
• Because somebody pays for these “external” costs and others receives the
benefits.
• Economic analysis is, therefore, conducted to identify the cost and benefits
where there is a significance divergence between market prices and economic
values.
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• The prices used in the valuation of inputs and output: In financial analysis,
the rule is to value inputs and outputs at actual market prices, whereas in
economic analysis; shadow, efficiency or accounting prices are employed.
• Consequently, using different prices will give different economic and financial
NPV, IRR, BCR and others even if the inputs and outputs are identical in
physical terms.
• The treatment of taxes, subsidies and other transfer payments is another
reason why financial and economic NPV,IRR and BCR might differ emanates
from the treatment.
•
This issue relates to the valuation of inputs and outputs is treated separately
because of its importance in practice.
• Taxes and customs duties are taken as cost in financial analysis although they
do not reflect the commitment of real resources from which the enterprise is
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• For this reason they are excluded from the calculations of the economic
NPV,BCR,IRR and others.
• The impact of the project on savings, its effect on redistribution, and the
consideration for merit goods are seen as another additional factors that entail
differences between financial and economic analysis of projects.
• While setting up a project, issues not necessarily connected with the financial
profitability but also to the environment and society as a whole is important in
the economic analysis of projects.
• These issues relate to environmental pollution, safety and different segments of
the society in contact with the activities of the project are externalities and
sunk cost.
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4.2 Sunk Costs and Transfer payments
•
Sunk costs are those costs incurred in the past upon which a proposed new
investment will be based.
• When we analyze a proposed investment, we consider only future returns
to future costs; not sunk costs which are expenditure in the past that do not
appear in both financial and economic accounts.
• Money spent in the past is already gone; we do not have any one as
alternative to implement a competed project.
• Taxes, subsidies and interest rates are considered to be transfer payments.
• These are the command of the government for transferring the resources
from one party to another without changing the amount of resources
available as a whole” (ADB, 1997) and hence, government is the distortion
factor for the market.
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• Taxes: In economic analysis, taxes are transfer payments within a society, not
the payment for resources used in projects. Hence, tax is eliminated from cost.
• Subsidies: If government subsidizes a project implemented by a private firm,
this subsidy is accounted as a benefit for the private firm.
• However, from the viewpoint of national economy, subsidies are also transfer of
cost among the members of the country. Therefore, subsidies are also eliminated
from the cost or benefit.
• Interest: the capital interest, a benefit of capital invested in any activities, is not
the cost used for consuming resources for the project but a kind of accounting
operation like depreciation cost.
• Also interest is a transfer of value among the members of the country where
from borrower to lender and hence, interest is eliminated from project cost.
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4.3 Conversion and Adjustment Factors for Project Analysis
• Ideally, all project inputs and outputs should be valued directly at accounting
prices.
• However, this is not always possible because some of the goods and services
are not traded and for them you know only the domestic price.
• This domestic price, most of the times is distorted and therefore, it should be
translated into shadow prices using conversion factors.
• As we know the prices of traded goods are obtained from the international
market whereas price of non-traded goods are obtained from the internal
market.
• To adjust the level of prices obtained from different markets, some converting
factors are applied.
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• Suppose that the price of export product is 100US$ in the internal market and the
government gives 10% of export subsidy to the trader of this good. With the
export subsidy, traders can sell the product to the international market with
90US$. Conversion factor of the good is calculated as
90/(90+10) = 0.9.
• Also international agencies like the World Bank have prepared conversion
factors for some countries. In such case, these conversion factors should be
utilized.
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• When converting the price of international market into that of internal
market, Shadow Exchange Rate is used and unit of currency in this case is
the one in the country, according to UNIDO method.
• The shadow exchange rate (SER) can be defined as rate of exchange
which accurately reflects the consumption worth of an extra unit of foreign
exchange in terms of the domestic currency.
• When converting the price of internal market into that of international
market, Conversion Factor (CF) is used, which most commonly known as
Little and Mirrlees method or OECD method.
• In this case, usually an international currency, namely, US$ will be the unit
of currency is converted to local currency by official foreign exchange rate
in the analysis.
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• Adjustment for the impact of project on merit goods and demerit goods
whose social values differ from their economic values
• 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 all, because it reduces dependence on foreign
supplies.
• The concept of merit goods can be extended to include a socially desirable
outcome like creation of employment.
• In the absence of the project, the government perhaps would be willing to
pay unemployment compensation
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4.3.1 Shadow Pricing
• Shadow prices are the real economic prices given to goods and services
after appropriately adjusted by removing distortionary market instruments.
• reflect opportunity cost which are the major national economic parameters
used to make economic analysis.
• are very important for project planners because they show the alternative
side of the project, what it will contribute to the economy and to the
society.
• Before dealing with shadow pricing of specific resources, we have to know
certain basic concepts and issues such
– choice of numeraire,
– concept of tradability,
– source of shadow prices,
– treatment of taxes, and
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• Choice of Numeraire: Just as to express market prices in terms of money,
an appropriate to measure shadow prices all in terms of a unit of account,
which is called the numeraire.
• In economic analysis, the value of inputs and outputs is expressed using
this numeraire, or unit of account.
• In the UNIDO approach, ‘aggregate consumption expressed in domestic
prices’ for inputs and outputs measured in terms of domestic prices that is
used as a numeraire or the unit of account.
• In the Little and Mirrless approach, ‘uncommitted or causal social income
measured values of goods are expressed in terms of border prices that is
used as the numeraire.
• Concept of Tradability: A key issue in shadow pricing is whether a good is
tradable for which the international price is a measure of its opportunity
cost to the country.
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• The application of opportunity cost is not workable, in the case where is no
opportunity cost or no alternative.
• Decisions about scarcity of resources allocation should be based on a careful
assessment of the opportunity costs of the alternatives. Because resources
have opportunity costs when they have alternative uses.
• To illustrate, assume that financial resources are scarce and the total
resources available with the financial institution for lending is Birr 10 billion
and there are three applications for finance viz., project A requiring
assistance of Birr 8 billion and project B requiring Birr 6 billion and project
C requiring Birr 4 billion .
• The opportunity cost of project A is more than project B and C. Even if all
projects are profitable, feasible and if the net benefits from A’s higher than
the aggregate net benefits from B and C, project A should be preferred
according to the opportunity cost principle.
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• Shadow pricing of specific economic resources such as land, labor, capital,
traded and non-trade goods can best be explained by referencing to
commonly used in the economic analysis of projects.
• The opportunity cost of land can be investigated by asking what the next
best alternative use of the land might be.
• For instance, urban land can be used for houses, offices, shops, factories
and like whereas rural land is normally used for crops, pasture, forestry or
sometimes conservation.
• Hence, the opportunity cost of rural land is likely to be very important in
the assessment of agricultural or agro industrial project than the alternative
ones, when agricultural land is being used.
• Opportunity cost of labor is the value of the worker's output in the next
best alternative and usually varies significantly between occupational
groups and often between regions.
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• In determining the opportunity cost of labor, it is important to identify the
potential source of labor in urban or rural.
• Project appraisal also distinguish between skilled and unskilled labor and the
most common assumption is that skilled labor is in scarce supply and has an
opportunity cost equal or greater than its market price,
• While unskilled labor is in excess supply and has an opportunity cost below
its market price.
• For instance, the opportunity cost of self-employment is the salary for the
best job he could have obtained. But if he does not have any job opportunity
other than the self-employment, there is no opportunity cost for the selfemployment.
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• Opportunity cost of capital (investment funds) for an economy is the rate
of return available on the next best alternative project.
• However, it is not easy to directly estimate the opportunity cost of capital for
an economy at large because economic analysis using shadow prices is not
applied consistently to all projects.
• Amount of opportunity cost of capital is usually expressed by percentage,
since the benefit that accrues from capital is focused as the ratio of benefit to
the capital.
•
For example, benefit of loan, which is the benefit of capital, is expressed as
interest rate.
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Opportunity cost of traded and non-traded commodities
• The opportunity cost for traded goods of an economy is defined by their
border prices which consists of cost insurance and freight (CIF) for
imports and freight on board (FOB) for exports.
• Assume that the country produces has a textile factory uses locally
produced cotton as a raw materials, the alternative is to export the raw
material, cotton.
• The opportunity cost of using the cotton for the textile project is the
export price (FOB) foregone.
• However, goods and services produced and sold in a country only are
defined as non-traded.
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• Rationale for using world prices as ‘shadow prices’ in the shadow pricing
philosophy:
– Traded goods for which the elasticities of demand and supply in
the market are infinite;
– Traded goods which are having definite elasticities of demand and
supply are in the global markets;
– Non-traded goods that are not being traded and will never be
traded provided optimal trade policies are employed by the
economy;
– Potentially traded goods that are not presently traded but can be
traded if the trade policies are optimal.
• In all the above cases, world prices are recommended to be used as shadow
prices since domestic pricing policies keep changing.
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• Non-traded goods and services do not enter the world trade either because
of their nature, such as electricity, unskilled labor, inland transport and etc.,
or due to trade barriers and other special reasons, which include high
transport cost and government policy.
• Often, non-traded items is bulky goods such as straw and highly perishable
goods such as fresh vegetables in which by their very nature tend to be
cheaper to produce domestically than to import
• The value of non-traded items is estimated by decomposing them into traded
and non traded elements.
• The former is valued at boarder price directly and the later at specially
estimated shadow prices.
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4.3.2 Valuation of Traded and Non-traded commodities
• Traded or tradable goods are valued on the basis of their marginal
international border prices, specifically known as cost insurance and
freight (CIF) for imports and free on board (FOB) for exports.
• The valuation of non-tradable goods is done as per the principles of shadow
pricing. On the output side:
– If the impact of the project is to increase the consumption of the
product, the measure of value is the marginal consumers’ willingness to
pay;
– If the impact of the project is to substitute other production of the same
non- tradable in the economy, the measure of value is the saving in cost
of production.
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On the input side:
– If the impact of the project is to reduce the availability of the input to other
users, their willingness to pay for the input represents social value;
– If the project’s input requirement is met by additional production of it, the
production cost of it is the measure of social value.
• Example, importing tractor:
Cost of production
= US$ 20,000
Cost of loading for shipment = US$ 2,000
Freight charge
= US$ 2,500
Insurance
= US$ 1,000
CIF
= US$ 25,500
Exporting Coffee per ton
Farm-gate price
Handling charge
Transport to port
Warehousing
FOB
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= Birr 1,000
= Birr 10
= Birr 100
= Birr 20
= Birr 1,130
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4.3.3. Border Parity Pricing
• If a project produces a good that enjoys protection, the project’s financial NPV
may be higher than under conditions of free trade.
• So, the market prices need to be adjusted to reflect the real economic values of
tradable inputs and outputs.
• For traded goods, the domestic margins relating to transport and distribution
including port handling will have to be adjusted to prices at the border.
• The decomposition of these margins is referred to as border parity pricing.
• A parity price or parity economic value is the price or value of a project input
& output that is based on a border price adjusted for expenses between border
and the project boundary.
• The economic principle involved is that production of a traded good has a dual
effect, both in terms of direct foreign exchange and the resources that go into
its distribution between the
project location and the border.
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• For goods that are traded directly by a project, the border parity price for the
project output is the FOB price minus the value of transport and distribution.
• In computing border parity prices, we used official exchange rate (OER) to
convert the border prices into local currency.
• This procedure assumes that OER is appropriate to make the two prices
comparable.
• Border prices of tradable goods valued at foreign currency and non-tradable
services like local transportation valued in domestic currency, which are two
prices of two categories types of the cost components.
• This cuts across both categories of goods, the tradable and non-tradable goods.
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4.3.4 National Parameters and Standard Conversion Factor
• There are some important parameters that have a general applicability in the
sense that they are used in all projects taking the same value although they
can change from time to time.
• In other words, such parameters are national in that they apply to all projects
regardless of their sector
• A project analyst can apply these national parameters directly to the project
under analysis.
• The national parameters are distinguished from the project specific shadow
prices, are estimated by central planners and are taken as given by the project
analyst.
• How many parameters should be estimated depends upon the economic
conditions of the country and the degree of sophistication desired in project
analysis.
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• All values should refer to the same year or an average over the same
period.
• The border price is obtained by multiplying the net of taxes domestic price
of the commodity by the SCF.
• Thus every effort must be made to decompose the non-tradable goods into
traded and non-tradable elements and the rule for the non-tradable goods
should be still decomposition and the SCF should be used only when this is
impossible.
• The SCF is revised from time to time by the central economic authorities
and adopted by planning bodies.
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4.3.5 The Premium on Foreign Exchange and the Shadow Exchange Rate
• The official exchange rate(OER) will be equal to the true economic value placed
on foreign exchange:
• if it is able to move freely without intervention by the government
and
• if there is no rationing of foreign exchange, no tariffs and nontariff barriers on imports and no taxes and subsidies on exports.
• In countries where these conditions hold, the market price of OER should be a
good measure of people's willingness to pay for the foreign exchange needed to
buy imported inputs.
• However, in many developing and developed countries, there are many
distortions in the market for foreign exchange and traded goods.
• The market for foreign exchange may be strictly controlled and only be possible
to purchase foreign exchange for permitted purposes
• Because the fixed official exchange rate is overvalued, which results in the
demand for foreign exchange greatly exceeding supply and the official exchange
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• The FEP, therefore, shows the extra percentage local residents would be
willing to pay for foreign exchange, above the official exchange rate, if
they were able to buy currency freely and spend it on duty- free goods.
• If no correction is made for this premium on foreign exchange in economic
appraisals, projects that produce traded good outputs will yield an NPV that
is undervalued, compared with those producing non-traded goods.
• This occurs because the traded good outputs would be valued at their CIF
border prices, converted into local currency at the artificially low official
exchange rate, in terms of local currency per $US.
• If both traded and non-traded commodities are used or produced in a
project, they need to be valued in comparable prices before they can be
added together in the net cash flow of the project.
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• Assume that in a particular economy there are only two homogeneous
consumer products produced and consumed. One is a non-traded good,
housing, and the other is a traded good, automobiles.
• The average equilibrium price for both houses and automobiles in the
domestic market is Br. 100,000.
• At this price, consumers are just as indifferent to purchasing more
automobiles as to more housing, since both are equally valuable to them.
• However, automobiles are subject to a 100 per cent tariff and are sold on
the international market for only $US 10, 000 or Br.50 000 (t OER of Br. 5
to $US l).
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• Alternatively, if the project were designed to export automobiles, these
could be sold for $US 10, 000 of foreign exchange per automobile, from
the project would actually
have
a value
of for
Br.100,
000 to the economy at
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local market prices.
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For example, assume a country imports 100 cars for the price of $US 10, 000
and its tariff on cars is 100 per cent for sells, its SER will be calculated as
follows:
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4.4. Determining Economic Values of Projects
• Once financial costs and benefits have been determined and entered in the
project accounts, the analyst estimates the economic value of a proposed
project to the nation as a whole.
• The social cost-benefit analysis is a very significant tool to assess the overall
feasibility of a project.
• It is a tool for evaluating the value of money particularly of public
investments.
• It is a systematic procedure for comprehensive review of all the costs,
benefits, and effects of a project.
• The two principal approaches to social-cost benefit analysis(SCBA) of
projects have emerged in the late 1960s and early 1970s are the UNIDO and
the Little and Mirrlees approaches, respectively.
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• The UNIDO method approach to SCBA of project appraisal involves five
stages, each stage of which measures the desirability of the project from
different angles:
• Calculation of financial profitability of the project measured at market
prices (refers to Chapter 3).
• Obtaining the net benefit of project measured in terms of shadow,
economic or efficiency prices.
• Adjustment for the impact of the project on savings and investment.
• Adjustment for the impact of the project on income distribution.
• Adjustment for the impact of project on merit goods and demerit
goods whose social values differ from their economic values.
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• Stage one: Market prices represent shadow prices only under conditions of
perfect markets, which are almost invariably not fulfilled in developing
countries.
• Hence, there is a need for developing shadow prices and measuring net
economic benefit in terms of these prices.
• Stage two is concerned with the determination of the net benefit of the project in
terms of economic or efficiency prices also referred to as shadow prices.
• The UNIDO approach suggests three sources of shadow pricing, depending on
the impact of the project on national economy for any given input or output.
These are:
– The change in the total consumption of the economy,
– The change in production of the economy and
– The change in imports or exports of the economy.
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 Stage three and four of the UNIDO method are concerned with measuring
the value of a project in terms of its contribution to savings and income
redistribution.
– To facilitate such assessments, we must first measure the income gained
or lost by individual groups within the society.
– For income distribution analysis, the society may be divided into various
groups.
 The UNIDO approach seeks to identify income gains and losses by the
project, other private business, government, workers, consumers, and
external sector.
 The gain or loss to an individual group within the society as a result of the
project:
– equal to the difference between shadow price and market price of each
input or output in the case of physical resources
– the difference between price paid and value received in the case of
financial transaction.
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 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.
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Income Distribution Impact: Many governments regard a redistribution of
income in favor of economically weaker sections or economically backward
regions as a socially desirable objective.
 Due to practical difficulties in pursuing the objective of redistribution
entirely through tax, subsidy, and the government transfer:
– investment projects are considered as instruments for income
redistribution and
– The investment projects contribution toward the goal is considered in
the evaluation.
 This calls for suitably weighing the net gain or loss by each group,
measured earlier, to reflect the relative value of income for different groups
and summing them.
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• Some of the similarities the UNIDO and Little and Mirrlees method are the
calculation of shadow or accounting prices; the consideration the factor of
equity and the use of discounted cash flow analysis
• Despite considerable similarities, there are certain differences between the
two approaches:
– The UNIDO approach measures costs and benefits in terms of domestic
currency whereas the L-M approach measures costs and benefits in
terms of international prices, also referred to as border prices.
– 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.
– The stage-by-stage analysis recommended by the UNIDO approach
focuses on efficiency, savings and redistribution considerations in
different stages. The L-M approach, however, tends to view these
considerations together.
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Main Features and Limitation of Social Cost-benefit Analysis
Main Features
• Social-cost benefit analysis is a tool for evaluating the value of money
particularly of public investments.
• It implies the enumeration and evaluation of all the relevant cost and
benefits”.
• This definition focuses attention on the main features of cost-benefit analysis.
It covers five distinct issues:
– Assessing the desirability of projects in the public, as opposed to
the private sector.
– Identification of costs and benefits.
– Measurement of costs and benefits.
– Identifying the effect of risk and uncertainty in investment appraisal.
– Presentation of results– the investment criterion.
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Limitations of SCBA
• No standard method or technical applicable to all types of investment
project.
• However these limitation can be rectified by removing subjectivity in it.
• Another problem is the qualification and measurement of social costs and
benefits are formidable.
• This is because many costs and benefits are intangible and their evaluation
in terms of money is bound to be subjective.
• Moreover, a successful application of the techniques of analysis depends
upon the accuracy and reliability of forecasts.
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• Even when evaluation of social costs and benefits has been completed for
one project, it may be difficult to judge whether any other project would
yield better results from the social point of view.
• If all possible alternative investments are sought to be socially assessed, the
costs would be prohibitive.
• However, the limitations of analysis should not deter one from applying the
techniques so far evolved. The element of subjectivity can be reduced by
cross-checks.
• Even economic assessments suffer from certain drawbacks due to
distortions in the price-mechanism caused by imperfections in the labor
market, government controls, tariffs and quotas, and price inflation.
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4.4 Cost-Effectiveness
• We have so far focused on cost-benefit analysis which is an appropriate
technique for projects with benefits and costs that are measurable in
monetary terms.
• If the project measures its benefits in some non-monetary unit, the NPV
and other criteria for deciding whether to implement it cannot be used.
• In such cases, economic analysis can still be a great help in project design
and selection with multiple outcomes.
• Economic analysis enables us to compare the costs of various options with
their expected benefits as a basis for making choices.
• Two main techniques exist for comparing projects with benefits that are not
readily measurable in monetary terms are cost-effectiveness and weighted
cost-effectiveness.
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4.1 Cost-Effectiveness Measures
• We would use cost-effectiveness for projects with a single goal not
measurable in monetary terms, for example, provision of education to a
given number of children.
• Cost-effectiveness Analysis is a technique closely related to cost benefit
analysis.
• It aids choice between options but cannot answer the question whether or
not any of the options are worth doing.
• It is utilized when there are difficulties in associating monetary values with
the outcomes of projects but where the outcomes can be quantified along
some non-monetary dimension.
• In cost-effectiveness analysis, we measure the benefits in non-monetary
units, such as test scores and number of students enrolled.
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• Suppose we want to evaluate the cost effectiveness of four options to raise
mathematics skills (Levien 1983):
– Small remedial groups with a special instructor
– A self-instructional program supported with specially designed
materials
– Computer-assisted instruction
– A program involving peer tutoring
• We first estimate the effect of each intervention on mathematics skills as
measured by, say, test scores, while controlling for initial levels of learning
and personal characteristics.
• Suppose we find that students taught in small groups attain scores of 20
points, those undergoing the self-instructional program score 4 points, those
with computer-assisted instruction score 15 points, and those in the peertutored group score 10 points (as can be seen in Table 4.1).
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Table 4.1 Hypothetical cost-effectiveness ratios for interventions to improve
mathematics skills
Intervention
Size of effect
on test scores
Small group instruction
Self-instructional materials
Computer-assisted instruction
Peer tutoring
Cost per
student (US$)
20
4
15
10
300
100
150
50
Cost effective
ness ratio
15
25
10
5
Hence, results show that peer tutoring is the most cost-effective intervention
by considering cost-effectiveness; it attains one-third the gain of small group
instruction at only one-sixth the cost for a cost-effectiveness ratio of only 5
(see Table 4.1).
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• If, however, both the measure of benefits, test scores and the costs per student
vary among interventions, the analyst should use cost-effectiveness ratios
with caution.
• In the above case, computer assisted instruction produces a gain of five points
over peer tutoring at an additional cost of US$100, or US$20 per point.
• To choose peer tutoring over computer-assisted instruction solely on the basis
of cost-effectiveness ratios would be equivalent to saying that the marginal
gain in test scores is not worth the marginal expense.
• When using cost-effectiveness ratios, the analysts has to be advised to ask
whether an increase the intensity of the intervention, the combined
interventions, or the intervention’s marginal gain worth the extra cost can
have improve the results
• Cost-effectiveness analysis can also be used to compare the efficiency of
investment in different school inputs.
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4.2 Weighted Cost-Effectiveness Measures
• When the projects aim to achieve multiple goals not measurable in
monetary terms, we use weighted cost-effectiveness.
•
For example, several interventions may exist simultaneously increase
reading speed, comprehension, and vocabulary, but that are not equally
effective in achieving each of the goals.
•
A comparison of methods to achieve these aims requires reducing the three
goals to a single measure, for which we need some weighting scheme.
• Weighted Cost-Effectiveness: Sometimes project evaluation requires joint
consideration of multiple outcomes, for example, test scores in two
subjects, and perhaps also their distribution across population groups.
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• In such situations, the analyst must first assess the importance of each outcome
with respect to single goal
•
Usually a subjective judgment derived from one or many sources, including
expert opinion, policymakers’ preferences, and community views. These
subjective judgments are then translated into weights.
• Once the weights are estimated, the next step is to multiply each of the
outcomes by the weights to obtain a single composite measure.
• The final step is to divide the composite measure by the cost of the options
being considered. The results are called weighted cost-effectiveness ratios.
• Consider the data in Table 4.2 which show the effects of two improvement
strategies for three dimensions of reading skills, as well as the weights assigned
by experts to these skills on a scale of 0-10 points.
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Table 4.2 Weighting outcomes of two interventions to improve reading skills
Category
Weights assigned
by expert opinion
Intervention (Aa ) Intervention Ba
Reading speed
7
75
60
Reading comprehension
9
40
65
Word knowledge
6
55
65
Weighted test score b
n.a
1215
1395
Cost per pupil
n.a
95
105
Weighted cost-effectiveness ratio n.a
12.8
13.3
• n.a indicates not applicable
• a denotes the scores on each dimension of outcome are measured as
percentile ranking
• Assigning the weights is the trickiest part of the exercise; the rest of the
calculation is mechanical.
Source: Adapted from Levin (1983)
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• The weighted score of 1215 for intervention A equals (7x75+9x40+6x55) and
that of 1395 for intervention B equals (7x60+9x65+6x65).
• Dividing the weighted scores by the cost of the corresponding intervention at
a cost of US$95 per pupil for intervention A and US$105 per pupil for
intervention B, gives the weighted cost-effectiveness ratio with the more
favorable ratio is the latter.
• The weighted cost-effectiveness approach overcomes the difficulty of
insufficient information to choose between the strategies because of neither
dominates for both subjects by asking policymakers or other relevant
audiences to assign weights to the gain in test scores.
• The main advantage of weighted cost-effectiveness analysis is that we use it
to compare a wide range of project alternatives without requiring actual data.
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• However, the reliance on subjective data gives rise to important shortcomings in
weighted cost-effectiveness analysis.
• Given that the choice of respondents is itself a subjective decision, different
evaluators working on the same problem almost invariably arrive at different
conclusion using weighted cost-effectiveness analysis.
• The method also does not produce consistent comparisons from project to
project and preference scales indicate ordinal, rather than cardinal for
interpretations.
• Another problem is that the same score may not mean the same thing to
different individuals.
• Finally, there is the problem of combining the individual scores. Simple
summation may be appealing, but as pointed out in a seminal paper on social
choice, the procedure would not be appropriate if there were interactions among
the individuals (Arrow 1963).
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