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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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 1 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 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 2 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 3 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 4 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 5 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 6 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. Prepared by Urgaia Rissa (Ph.D.) for BA 09-Apr-24 Degree: [email protected] 7 • 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 Prepared by Urgaia Rissa (Ph.D.) for BA not exempted 09-Apr-24 8 Degree: [email protected] • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 9 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 10 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 11 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 12 • 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$. Conversion factor of the good is calculated as 90/(90+10) = 0.9. • Also international agencies like the World Bank have prepared conversion factors for some countries. In such case, these conversion factors should be utilized. Prepared by Urgaia Rissa (Ph.D.) for BA 09-Apr-24 Degree: [email protected] 13 • When converting the price of international market into that of internal market, Shadow Exchange Rate is used and unit of currency in this case is the one in the country, according to UNIDO method. • The shadow exchange rate (SER) can be defined as rate of exchange which accurately reflects the consumption worth of an extra unit of foreign exchange in terms of the domestic currency. • When converting the price of internal market into that of international market, Conversion Factor (CF) is used, which most commonly known as Little and Mirrlees method or OECD method. • In this case, usually an international currency, namely, US$ will be the unit of currency is converted to local currency by official foreign exchange rate in the analysis. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 14 • 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 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 15 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 16 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 17 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 – consumerPrepared willingness to pay. by Urgaia Rissa (Ph.D.) for BA 09-Apr-24 Degree: [email protected] 18 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 19 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 20 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 21 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 22 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 23 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 24 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 25 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 26 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 27 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 09-Apr-24 = Birr 1,000 = Birr 10 = Birr 100 = Birr 20 = Birr 1,130 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 28 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. Prepared by Urgaia Rissa (Ph.D.) for BA 09-Apr-24 Degree: [email protected] 29 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 30 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 31 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 32 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 33 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 Prepared by Urgaia Rissa (Ph.D.) for BA rate understates domestic currency 09-Apr-24 34 Degree: [email protected] 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 35 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 36 • 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). 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 37 • 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 Prepared by Urgaia Rissa (Ph.D.) BA 09-Apr-24 38 Degree: [email protected] local market prices. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 39 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: 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 40 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 41 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 42 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 43 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 44 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 45 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 47 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 48 • 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. Prepared by Urgaia Rissa (Ph.D.) for BA 09-Apr-24 Degree: [email protected] 49 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 50 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 51 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 52 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 53 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 54 • 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). 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 55 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). 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 56 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 57 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 58 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 59 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) 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 60 • 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. 09-Apr-24 Prepared by Urgaia Rissa (Ph.D.) for BA Degree: [email protected] 61 • 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). Prepared by Urgaia Rissa (Ph.D.) for BA 09-Apr-24 62 Degree: [email protected]