0 Updated: 06/03/2007 Lecture Notes ECON 622: ECONOMIC COST-BENEFIT ANALYSIS Lecture Two

1 PRINCIPLES UNDERLYING THE ECONOMIC ANALYSIS OF PROJECTS

2 Introduction to Economic Analysis The financial analysis of a project focuses on its financial attractiveness to its private investors. The economic analysis measures the impact of the project on the entire society. An economic analysis of a project helps determine whether the project increases the net wealth of a Country’s society as a whole or not. A project with a negative economic net present value will serve to shrink the economy rather than grow it. For example if $1000 investment and NPV equals to $ Then the project uses 1000 of resources and only produces 730 of value.

3 Estimation of Economic Prices Financial prices are market prices, which are affected by the various tariffs, taxes, and subsidies. Economic values may differ from financial prices because: 1.consumers valuation of an item may be greater than financial price they pay eg. road usage, water. 2.financial costs may not be the true costs eg. Natural gas is sold to electricity utility in Egypt at a financial price that is only 1/3 of international opportunity cost. Calculating the economic values requires an understanding of how to integrate financial values, tariffs and taxes, handling and transportation costs, and exchange rate distortions.

4 Commodity Specific Conversion Factors (CSCF) Financial prices are market prices, which incorporate all the tariffs, taxes, and subsidies. We use the conversion factor to convert each of the financial cashflow into the economic cost or benefit in the economic resource statement in the economic appraisal. Suppose, the project is using (purchasing) cotton yarn, the relevant financial price to the project would be the demand price, P d, (the price paid by the project). The financial price to the project is R22,239 and the economic value is R18,794. The economic value is less than financial price because the economic value doesn’t include tax.

5 Example of Financial and Economic Cashflows: the Case of Electricity Project Table of Parameters for Economic Analysis Economic Opportunity cost of capital10% Economic Opportunity cost of Labor80%of financial wage bill Foreign Exchange Premium15% Subsidy on Gas30% of Financial Cost Willingness to pay for electricity3.00Rs/Kwh Resource flow: Economic Points of View (millions Rs.) Year CF* Inflows Sales4500 Land (Subsidy)0.000 Liquidation value of land Total Inflows Outflows Land Long term investment Machinery Equipment Gas** Coal Labor Wages Total Outflows10, Net Cashflows *CF = Conversion Factors 1.36 Table of Parameters for Financial Analysis Price of Electricity2.20Rs/KwhLong term investment Production of Electricity1,500Gwh/year Machinery8000 Equipment1290 Gas0.25per KwhFinancial Cost Land (Given as subsidy) 300 of Capital12% Coal0.15Rs/Kwh Cashflow: Financial Points of View (millions Rs.) Year Inflows Sales3300 Land (Subsidy)300 Liquidation value of investment0 Liquidation value of land300 Total Inflows Outflows Land300 Long term investment Machinery8000 Equipment1290 Gas375 Coal225 Labor Wages120 Total Outflows9, Net Cashflows **CF for gas = [(1.3)*(1.15)]/1 = 1.5

6 Three Postulates Underlying the Economic Evaluation Methodology These postulates in turn are based on a number of fundamental concepts of welfare economics. The competitive, demand price for an incremental unit of a good or service measures its economic value to the demander and hence its economic benefit. The competitive, supply price for an incremental unit of a good or service measures its economic resource cost. Costs and benefits are added up without regard to who the gainers and losers are.

7 What is the implication of these postulates for the economic analysis of a project? First Postulate The competitive demand price or the consumer’s willingness to pay for each additional unit of consumption measures the economic benefit or the economic price of each incremental unit. The demand curve reflects indifference on part of the consumer between having a particular unit of a good at that price and spending the money on other goods and services. Demand A Q0 P 1 = C Data Traffic (minutes/ year) Q1Q1 (MWTP) P 0 = Tariff /Coping Cost (US$/minute) Economic Value of Local Calls for Rural Customers Economic value = Q 0 ACQ 1 = Willingness to Pay Consumer Surplus (P 1 AC) Payment for services

8 What is the implication of these postulates for the economic analysis of a project? (Cont’d) Second Postulate The competitive supply price of each incremental unit of a good measures the economic cost of the resources (inputs) that goes into the production of that unit. The supply (marginal cost) curve represents the minimum prices that suppliers are willing to accept for successive units of a good or service that they supply. In a competitive market these minimum prices represent the marginal opportunity cost of these goods. Suppliers will be indifferent between selling incremental units of the good at their supply prices or using the factors to produce other goods and services. Q0 MC Number of rural telephone calls Cost Q1Q2 O Installation (Marginal Cost) of one more terminal and demand for rural telephone calls D1D1 D2D2

9 Third Postulate Costs and benefits are added up without regard to who the gainers and losers are. Should the project be valued differently depending on whom are the beneficiaries and the losers? – Not by the economic analysis This methodology measures the net economic benefit of the project by subtracting the total resource costs used to produce the project’s output from the total benefits of the output. It adds up the currency values of the net economic benefits regardless of who are the beneficiaries or losers of the project. This approach attempts to separate the social aspects of project appraisal from the economic efficiency aspects. What is the implication of these postulates for the economic analysis of a project? (Cont’d)

10 Analyzing Economic Costs and Benefits in an Existing Market (in the absence of a new project) Economic Costs and Benefits in an Existing Market Consumer surplus Producer surplus

11 Illustration of Basic Postulates and Cost/Benefit Accounting Framework Calculation of Net Economic Benefit Using Postulate 3: A Dollar is a Dollar Price soso Net Economic Benefit = Total Economic Benefit - Total Economic Cost = (A + B + C)- (C) Net Economic Benefit = Consumers’ Surplus + Producers’ Surplus (A + B) = (A) + (B) Consumers’ Surplus = Total Economic Benefits - Total Revenues A = (A + B + C) - (B + C) Producers’ Surplus = Total Revenues - Total Economic Cost B = (B + C) - (C) m0m0 Quantity per year B = Producers’ Surplus A = Consumers’ Surplus C = Gross Economic Costs A C B Q0mQ0m D S dodo PP == P 0

12 Analyzing Economic Costs and Benefits in an Existing Market (in the absence of a new project) The analysis above indicates that the gross economic benefits from the consumption of the output from this industry is greater than the financial revenues received by the suppliers due to the consumer surplus enjoyed by the consumers of the output. It also indicates that the economic cost of producing the output is less than the financial revenues received by the suppliers yielding a producer surplus to the owners of the supply facilities. The implication of these two facts is that the financial price of a unit may be different from its economic price even in the absence of distortions.

13 Estimation of Economic Prices In order to estimate the true economic value of a good or service, one needs to know: Tradable, Non-Tradable or Rationed Is the good non-tradable (domestic)? Is the good or service now being rationed? Is the good internationally tradable? The difference is whether the price of the good is determined by the forces of demand and supply in the domestic market or given to the country by international markets.

14 Defining a Price of Internationally Non-Traded (Domestic) Good or Service Goods and services whose domestic production satisfies all the domestic demand for these items and whose domestic prices are not affected by their world prices are referred to as non-traded goods. Distorted World Supply Price Price Quantity per year Domestic Supply Domestic Demand D S E m * P FOB * (1-t x ) - F x PmPm E m * P CIF * (1+T m ) + F m Distorted World Demand Price Domestic price

15 Analyzing the Economic Benefits of an Non- Traded Output Produced by a Project Economic Benefits of a New Project in an Undistorted Market

16 Analyzing the Economic Cost of an Input Demanded by a Project Economic Cost of an Input Demanded by a Project in an Undistorted Market

17 Small versus Large Changes in Prices Often the quantity produced by a single project or purchases as inputs by a project, is relatively small compared to the size of the market and hence there is little or no change in the market price. In such a situation and given that we are operating in an undistorted market, the gross financial receipts will be equal to the gross economic benefits. The triangle ABC is very small. A difference arises only when the quantity produced by the project or demanded by the project is sufficiently large to have an impact on the prevailing market price in the sector.

18 Applying the Postulates to Determine Economic Evaluation of Non-Tradable Goods and Services in Distorted Markets Distortions are defined as market imperfections. The most common types of these distortions are in the form of government taxes and subsidies. Others include quantitative restrictions, price controls, and monopolies. We need to take the type and level of distortions as given and not changed by the project when estimating the economic costs and benefits of projects. The task of the project analyst or economist is to select the projects that increase the net wealth of country, given the current and expected regime of distortions in the country.

19 Sales Taxes Levied on Output of Project Economic Cost of an Input Demanded by a Project --- when a tax is imposed on sales --- Financial cost is P 1 d (Q 1 s -Q 1 d ) Economic cost is Q 1 d C ’ B ’ BAQ 1 s

20 Sales Taxes Levied on Output of Project Economic Benefit of an Output Supplied by a Project --- when a tax is imposed on sales --- Financial benefit is P 1 m (Q 1 d -Q 1 s ) Economic benefit is Q 1 s CBB ’ A ’ Q 1 d P d =P m +T if unit tax P d =P m (1+t) if ad valorem

21 Subsidies on Production Economic Benefits of a New Project -- when a production subsidy is present -- Financial benefit is P 1 m (Q 1 d -Q 1 s ) Economic benefit is Q 1 s A ’ B ’ BCQ 1 d Or if subsidy is proportion of total cost,and

22 Environmental Externalities A Project with Pollution in the Lake Financial benefit is P 1 m (Q 1 d -Q 1 s ) Economic benefit is Q 1 s A ’ B ’ BCQ 1 d

23 Calculating the Economic Value of Non-Tradable Goods Economic Value = W x s P s + W x d P d = weighted average of supply (P s ) and demand (P d ) price Where: W s + W d = 1 If Rationing then, W s = 0 and W d = 1 Traded : Importable W s = 1 and W d = 0 Exportable W s = 0 and W d = 1 Non-Traded W s > 0 and W d > 0 Three classes of goods: W s W d 2/3 1/3 1/2 1/2 1/3 2/3

24 W x s = Supply Elasticity  Supply Elasticity - Demand Elasticity  -  = W x d = Demand Elasticity -  Supply Elasticity - Demand Elasticity  -  = P s = Supply Price P d = Demand Price  = (defined positively)own price elasticity of supply  = (defined negatively) own price elasticity of demand Weights expressed in terms of elasticities: WxsWxs WxdWxd  -- = Calculating the Economic Value of Non-Tradable Goods

25 Applying the Postulates to Determine Economic Evaluation of Tradable Goods and services The framework for the estimation of economic prices was presented for the case of non-tradable goods. They are also applicable to the valuation of tradable goods. These postulates are general in nature and are also applicable to tradable goods. The methodology for the estimation of the economic prices of internationally tradable goods and services when there are distortions in their markets is also based on the three postulates. These distortions may include customs duties on imported inputs of a project or those imported items that the project output will replace or substitute.

26 The Economic Opportunity Cost of Capital One of the practical ways to measure this parameter is to use the economic opportunity cost of funds that are drawn from the capital market. In a small, open and developing economy, there are three alternative sources for these public funds. The first source comes from those resources that would have been invested in other investment activities that have been either displaced or postponed by our project’s extraction of funds from the capital market. The second source is from individual savers whose resources would have been spent on private consumption due to an increase in domestic savings. The third source is additional foreign capital inflows.

27 Foreign Exchange Externality The foreign exchange externality is meant to capture any indirect external welfare effects that result from a project's incremental use or production of foreign exchange. The source of this externality lies in the divergence that exists between the marginal value of a unit of foreign exchange and the marginal cost of earning that unit. This divergence is ultimately due to import tariff, export taxes, sales taxes, excise taxes and any other tax or quantitative restrictions distortions in the markets underlying the demand and supply of foreign exchange.

28 The Economic Opportunity Cost of Labor In the labor market there are a variety of factors that may create a divergence between the market wage and the economic cost of a worker at the project. This cost of employment, referred to as the supply price of labor, reflects both the value of the market and non-market activities undertaken by the worker prior to joining the work force at the project and all other factors that govern the desirability of working at the project. It will also take into account any tax differentials that the worker may face as a result of moving to the project from another employment or unemployment