Benefit-Cost Analysis Course: Referent Group Analysis Financial and Economic Appraisal using Spreadsheets Ch. 6: Referent Group Benefit-Cost Analysis © Harry Campbell & Richard Brown School of Economics The University of Queensland © Harry Campbell & Richard Brown, School of Economics, University of Queensland, 2003

Excluded parts Example 6.5: A Regulated Utility Example 6.6: Monopoly Power Example 6.7: Monopsony Power

Benefit-Cost Analysis Course: Referent Group Analysis Referent Group Net Benefits What is the “referent group”? - it is the group whose net benefits are relevant to the decision-maker who commissioned the SBCA. What will the referent group normally consist of? - all residents of a region, state or country - all members of a social group, for example, pensioners, native peoples etc. © Harry Campbell & Richard Brown, School of Economics, University of Queensland, 2003

Benefit-Cost Analysis Course: Referent Group Analysis If only referent group benefits are relevant, why bother to calculate efficiency net benefit? Efficiency net benefit is the aggregate net benefit for the project as a whole, using opportunity cost as efficiency prices. The sum of referent group and non-referent group net benefits must equal the efficiency net benefit. This relationship provides a check on the consistency of the BCA as a whole. © Harry Campbell & Richard Brown, School of Economics, University of Queensland, 2003

Recall Figure 1.3: (we add segment D) A B D (=referent group net benefits not captured by market prices) A (= referent group net benefits) B (= non-referent group net benefits) D = non-ref. group non-market net benefits

Why do we need BCA to identify referent group net benefits? A project evaluation will only capture benefits and costs which are fully measured by market prices. It fails to capture various public interest aspects of a project. For example: - employment benefits - indirect tax revenue changes - pollution costs etc.

Four-way Classification of Net Benefits Figure 6.1: Classification of Net Benefits Net benefits accruing to: Referent Non-referent Group Group Captured A B by market prices Not captured by C D market prices

Graphical Representation of Classification

In specific cases some of the cells in the four-way classification can be empty. For example, in figure 1.3 cell D was empty (and was omitted from the diagram) because there were no non-referent group net benefits that were not captured by the market. Such net benefits might have resulted from global pollution or from market imperfections in the foreign country.

In general, what cells in the four-way classification could be empty? If C+D is empty, then the project analysis coincides with the efficiency analysis. 2. If A+C is empty, then the project has no relevance for the Referent Group. 3. If B+D is empty, the non-referent group is not affected by the project. 4. If A+B is empty, the project does not involve any inputs or outputs traded in the market.

How do we identify the various categories of disaggregated Referent Group net benefits? 1. Follow the financial flows: - division of project profits between referent and non-referent group members; - identify direct and indirect tax flows, e.g. business income tax, sales tax, tariffs etc. 2. Learn from the shadow-prices: - where there is a shadow-price, the project analysis has failed to pick up an efficiency net benefit that must be assigned to either the referent or non-referent group.

Figure 6.1: Using Shadow-prices to Identify Referent Group Benefits or Costs Input Output Market Price Benefit to the Cost to public Greater than Owner of the or Government Shadow-price input eg. eg. loss of unemployed tariff revenue, labour cost of pollution generated by use Market Price Cost to alternative Benefit to Less than user of the input general public Shadow-price eg. monopoly or eg. vaccination monopsony employer

To Recap: How do we approach BCA? 1. Do the project analysis first (A+B) because of availability of data. 2. Do the private analysis, i.e. identify the subset of A+B that affects private equity-holders. 3. Do the efficiency analysis (A+B+C+D) using shadow-prices and non-market valuations where appropriate. 4. Calculate aggregate Referent Group net benefits: (A+B+C+D) - (B+D) = (A+C) 5. Calculate disaggregated RG net benefits (A1+ A2+ A3+ C1 + C2 + C3) and do a check.

Example 6.1: Minimum Wage (based on Example 5.1) A domestic firm hires $100 worth of labor at the minimum wage and constructs a walking track for which it is paid $110 by the government. No fee is charged to access the track, and it has a present value of $120 to consumers. The labor would otherwise be unemployed and would be in non market activities valued at $50. Efficiency net benefit = $120-50 = $70 Distribution of net benefits: Project net benefit = A+B = $10 Efficiency net benefit = A+B+C+D = $70 Referent group net benefit = A+C = $70 Non-referent group net benefit = B+D = $0 A=$10 Profits to firm=$110-100=$10 B=$0 None C=$60 Rent to labor=$100-50=$50 Benefits to users=$120 Loss to Government=$-110 D=$0

Example 6.2: Maximum Price (based on Example 5.3) A state government hires a computer programmer from another state for a month, at a cost of $200, which is $50 more than she would normally expect to earn, and pays $100 for the accommodation of the programmer in a rent controlled apartment with a market value of $125. The programmer revises some of the government’s programs leading to a cost saving of $400. Efficiency net benefit = $400-150-125 = $125 Distribution of net benefits: Project net benefit = A+B = $100 Efficiency net benefit = A+B+C+D = $125 Referent group net benefit = A+C = $75 Non-referent group net benefit = B+D = $50 A=$100 Net benefits to government department=$400-200-100=$100 B=$0 None C=-$25 Loss of rent to potential renters=$-25 D=$50 Rent to labor=$200-150=$50

Tariff revenue to government=$25 Example 6.3: An Indirect Tax - a Tariff on Imports (based on Example 5.4) Part a – Imports as an input to production A domestic firm proposes to import $100 worth of gadgets for use in a manufacturing project. The $100 includes the c.i.f. (landed) value of the imported goods of $75 plus $25 in tariffs. Other costs are $200 for skilled labor, and the resulting would sell on the domestic market for $400. Efficiency net benefit = $400-75-200= $125 Distribution of net benefits: Project net benefit = A+B = $100 Efficiency net benefit = A+B+C+D = $125 Referent group net benefit = A+C = $125 Non-referent group net benefit = B+D = $0 A=$100 Profits to firm=$400-200-100=$100 B=$0 None C=$25 Tariff revenue to government=$25 D=$0

Tariff loss to government=-$100 Example 6.3: An Indirect Tax - a Tariff on Imports (based on Example 5.4) Part b – Import replacing project A domestic firm produces a good which is currently imported. The project uses $200 worth of skilled labor to produce output valued on the domestic market at $400. Domestic consumers could obtain that same quantity of output from abroad at a cost of $300 c.i.f. plus $100 tariff. Efficiency net benefit = $300-200= $100 Distribution of net benefits: Project net benefit = A+B = $200 Efficiency net benefit = A+B+C+D = $100 Referent group net benefit = A+C = $100 Non-referent group net benefit = B+D = $0 A=$200 Profits to firm=$400-200=$200 B=$0 None C=-$100 Tariff loss to government=-$100 D=$0

Example 6.4: A Subsidy (based on Example 5.5) The government spends $100 on constructing wheat silos, the services of which are supplied free to users, which results in farmers saving $75 worth of diesel fuel at the subsidized price. The subsidy paid on that quantity of fuel amounts to $25. Efficiency net benefit = $75+25-100= $0 Distribution of net benefits: Project net benefit = A+B = -$25 Efficiency net benefit = A+B+C+D = $0 Referent group net benefit = A+C = $0 Non-referent group net benefit = B+D = $0 A=-$25 Net benefits to farmers=$75 Project cost to government=-$100 B=$0 None C=$25 Government’s saving on subsidies=$25 D=$0

Example 6.8: Where the Project and Efficiency Net Benefits are the Same A local firm engages a foreign contractor to assist with the upgrade of an existing plant. The foreign contractor is paid a management fee at the going international rate of $300. The firm spends a further $500 on new technology, purchased abroad at the current world price. The result is an increase in the firm’s output of exports, sold at the going world price, equal in value at $1200. The firm pays $100 additional taxes to government and shares the remaining profit 50:50 with the foreign contractor. Efficiency net benefit = $1200-300-500 = $400 Distribution of net benefits: Project net benefit = A+B = $400 Efficiency net benefit = A+B+C+D = $400 Referent group net benefit = A+C = $250 Non-referent group net benefit = B+D = $150 A=$250 Profits to local firm=$1200-800-100-150=$150 Taxes to government=$100 B=$150 Profits to foreign contractor= =50%*($1200-800-100)=$150 C=$0 None D=$0

Example 6.9: Where there are Market and Non-Market Non-Referent Group Net Benefits A farmer invests $400 in an irrigation project, including a new pump from an inter-state supplier on credit for $200. He employs some local casual labor for $100, and an inter-state irrigation consultant for $150. The value of his output of fruit at domestic prices increases by $800, but the project causes $10 in lost output due to reduced water flow to downstream users. He repays the credit to the pump supplier with $20 interest, and pays another $30 in taxes. The opportunity cost of the local labor is $50 and the opportunity cost of inter-state consultant is $100. The value of the farmer’s increased output at world prices is $750, which is the value at domestic prices less the tariff on imports of fruit. Efficiency net benefit = $750-400-50-100-10 = $190 Distribution of net benefits: Project net benefit = A+B = $150 Efficiency net benefit = A+B+C+D = $190 Referent group net benefit = A+C = $120 Non-referent group net benefit = B+D = $70 A=$130 Profits to farmer=$800-400-100-150-20-30=$100 Taxes to government=$30 B=$20 Interest to inter-state supplier=$20 C=-$10 Rent to local labor=$100-50=$50 Lossess to downstream users=-$10 Loss of tariffs to government=$750-800=-$50 D=$50 Rent to inter-state consultant=$150-100=$50