Economic Analysis Concepts

2 Is the project justified ?- Are benefits greater than costs? Which is the best investment if we have a set of mutually exclusive alternatives? If funds are limited, how should different schemes be ranked? When should the Application systembe built or upgraded? Questions & Decisions (1)

3 What standard of Development should be used? Are anycomplementary investments required? Questions & Decisions (2)

4 All appraisals need a framework or model for: a) Forecasting changes b) Evaluating those changes Appraisal Framework

5 Costs and benefits are measured in terms of invested money Systemdevelopment and maintenance costs are compared with estimates of the direct primary benefits going to system users Economic prices are used in constant terms Components of Economic Analysis (1)

6 Costs and Benefits are forecast over the planning time horizon (usually between 5 and 10 years) Future Benefits are valued  less time cosumption Components of Economic Analysis (2)

7 The cost to the economy of development and maintenance may differ from the financial cost because of : Type of work taxes The Organizations will usually be concerned with ECONOMIC costs. Economic and Financial Prices

8 In an Economic Appraisal we use ECONOMIC (or SHADOW) prices NOT FINANCIAL prices Adjust financial prices as follows: Exclude all taxes and cost and subsidies Use the planning discount rate not financial market rate If overvalued exchange rate then value imports and exports more highly Use the opportunity cost of worker Standard Conversion Factors (SE) are now widely used for road construction costs Use of Economic Prices

9 Management (including design and supervision) Workers Hardware Materials (Others) Environment Project Costs

10 Reduced operating costs (VOC) How.... Primary Effects (1)

11 Changes in Internal output Changes in services Changes in industrial output Changes in consumers behavior Changes in Profit Other Effects

12 Captures primary benefits Advantages: Simple, cost based, traffic approach dependent on predicting changes in usage Disadvantages: May not address critical factors during development or social access Consumers’ Surplus Approach

13 Captures secondary benefits Advantages: Draws attention to changes in output (key economic activity) Disadvantages: No reliable way of predicting response - impact studies give widely different answers - For most projects benefits are just invented ! Producers’ Surplus Approach

14 Increased Farmgate Price Lower Input Costs Price & Costs per Unit of Output Output O1O2 P2 P1 Example Producers’ Surplus

15 Any economic analysis should be designed to give maximum usage and benefits But we must avoid double counting. Do not add primary and secondary benefits In a competitive economy the consumers’ surplus approach should be adequate Coverage and Double Counting

16 Economic analysis involves a comparison of “With” and “Without” project cases An unrealistic “Without” case (i.e. with little maintenance) can give a false result A range of “With investment” cases should be analyzed to find the best solution Economic Comparisons

17 Development benefits arise from a combination of increased work load and reduced transport costs. Benefits may also include : Increased production Increased service provision Increased industrial activity Development Benefits

18 Economic Decision Criteria NPV IRR 3 NPV/CFYRR Project economic validity Mutually exclusive projects Project timing Project screening 1 Under budget constraint 2 Notes: 1. check for robustness to changes in key variables (sensitivity analysis) 2.with incremental analysis

19 The Net Present Value (NPV) of a project alternative relative to the without project alternative is the sum of the discounted annual net benefits. The Internal Rate of Return (IRR) is the discount rate at which the NPV is zero. NPV and IRR

20 1.If the NPV is positive, for the chosen discount rate, then the alternative is acceptable. 2.If the NPV is negative, for the chosen discount rate, then the alternative is unacceptable. 3.If the NPV is zero, for the chosen discount rate, then the alternative is indifferent to the without project alternative. NPV Decision Rule

21 When comparing project-alternatives, the Net Present Value (NPV) is used to select the optimal project-alternative (alternative with highest NPV) The Internal Rate of Return (IRR) or the B/C ratio are not recommended to compare alternatives of a given project Comparison of Alternatives

22 An Appraisal is carried out before an investment is made. Everything is uncertain. A Post evaluation may be made say 5 years after the investment. The investment is known and 5yrs of with case are known. The without case is unknown as is the remainder of the with case. Appraisals & Post Evaluations (1)

23 In Both Cases forecasting and evaluation models are required to come to an answer. Hence we can never be certain about the viability of an investment ! Appraisals & Post Evaluations (2)

24 Cost Effectiveness Analysis (CEA) Compares the cost of interventions with its predicted impacts and it is used where the benefits cannot be measured in monetary terms, or where the measurement is difficult It includes provisions that (a) the objectives of the intervention are indicated and are clearly part of a ampler program of objectives (such as reduction of the poverty); and (b) the intervention represents the smaller cost alternative of obtaining the indicated objectives It produces effectiveness indicators, such as Total Beneficiary Population per Investment or Investment per Beneficiary Population