Development Economics 1, KU Lecture 25 Project appraisal and cost-benefit techniques

Introduction How best to invest public money? Production often at cost above world prices because domestic prices are distorted Investment decisions based on distorted domestic prices will be misleading Activities may be uncompetitive in the long run (once competition prevails) It may be cheaper to import goods than produce them domestically

Appraisal types Financial appraisal determines if the project is profitable at market prices Economic appraisal takes account of social costs and benefits of the project, and of externalities Social appraisal in addition takes account of distributional consequences

Project cycle Identification Feasibility studies (engineering, environmental, institutional, etc) Investment / implementation phase (with annual reviews) Evaluation

Decision criteria Net present value Internal rate of return

From financial to economic appraisal Identify and value all direct and indirect effects in the vicinity of the project Identify price effects Identify effects on other sectors of the economy Value project benefits at social or efficiency prices Measure costs and factors of production used at social (opportunity) cost Discount using the social rate of discount

Two approaches UNIDO approach measures costs and benefits at domestic market prices taking consumption as numeraire Little-Mirrlees approach uses world prices (to reflect opportunity costs) and takes public savings as numeraire

Why do we need to correct market prices? Governments impose distortions on markets (eg an overvalued exchange rates) Market imperfections and monopolies raise prices Externalities imply that price differs from social value

Traded goods Opportunity cost = world price For a project that generates imports: use border price (c.i.f) For a project that generates exports: use border price (f.o.b) Correct for transport costs between site and border

Nontraded goods Use conversion factor CF = economic price(opportunity cost)/market price This is similar to a shadow exchange rate; we need to know the shadow price of foreign exchange

Factors of production: the discount rate Social discount rate often not equal to market interest rate Accounting rate of interest = rate of return on public investment Some use the rate of return on private investment (assuming public investment crowds out private investment, you want its return to be at least as high)

Factors of production: wages Market wages may be larger than opportunity cost of labour due to Minimum wage legislation Other labour market imperfections Dual economy; low marginal product in agriculture So adopt lower social wage rates Question: what does this mean for chocie of technology?

Conclusions Big efforts to make decisions based on social cost and benefits rather than market prices Projects may still fail in very distorted environments World Bank uses this a lot Major Danish public infrastructure investments have a CBA Danida uses it little Method has been revived in the context of environmental cost-benefit analysis Environmental economists have perfected the art of valuing non-market goods and bads