1. Learning Unit: Two Economic Analysis of Projects
Nara Hari Dhakal, Ph. D.
Visiting Faculty

2. Valuation of Inputs and Outputs
If price distortions are few, market price provide a reasonably good approximation of opportunity cost of inputs and outputs
If price distortions are high, market prices are poor reflection of those costs, and the financial assessment usually differs than the economic assessment
Shadow prices are used instead of market prices to reflect closely opportunity cost and benefits of the projects
Shadow pricing is extremely time consuming, and in practice only a few adjustments are undertaken

3. Types of Project Inputs and Goods
Type of project inputs:
Material inputs,
Public utilities,
Labor,
Land, and
Services
Type of goods/inputs
Tradable,
Non-tradable, and
Potentially tradable
Valuation of each types of goods/inputs is different

4. Tradable and Non-tradable Goods
Goods that are either imported or exported by the country
Includes all tradable goods and goods a country could import (or export) under conditions of free trade, but it does not trade due to trade barriers import duties
Example – materials inputs
Non-tradable goods
Goods that can’t be traded or are uneconomical to trade internationally
Examples: real estate, hotel accommodations, haircuts, and other services
Include goods whose costs of production and transportation are so high as to preclude trade, even under conditions of free trade
Cost Insurance and Fright (CIF) price (net of import duties and subsidies) of the good is higher than domestic price
Free on Board (FOB) price (net of export duties and subsidies) is lower than the domestic price
Potentially traded
Import duties render the import price higher than the domestic price
If export duties makes exports uncompetitive
They should be treated as non-tradable
Criteria:
Tradability – international trade

5. Valuation of Tradable Goods
Valuation of tradable inputs and outputs relies on “border” rather than on domestic market price
Border price are either CIF or FOB prices suitably adjusted for internal transport costs and other costs, but net of taxes and subsidies
Export-parity price:
FOB price of exports (if a country is net exporter of good in question)
Import-parity price:
CIF price of imports plus internal transport cost (if the country is net importer)

6. Import Parity Price
Price at which import substitute (eg. Maize) must be produced domestically if it is to compete with imports

7. Calculation of Import Parity Price
S.N.
Step in the Calculation
Relevant step
Financial Price 1
FOB at point of export
FOB - Birgung 2
Add freight, insurance, and unloading at point of import
Fee 3
Equals CIF at point of import 4
Convert foreign currency into domestic currency at official exchange rate
US$ 1 = Rs. 100 5
Add local port charge
Landing and port charge 6
Add local transport and marketing costs to relevant market
Transport 7
Equals price at market
Wholesale price 8
Deduct transport and marketing costs to relevant market
Primary marketing 9
Deduct local storage, transport, and marketing costs
Transport, storage loss 10
Equals import-parity price
Farm gate price

8. Export Parity Price
What price would farmers receive if they must produce for export?

9. Calculation of Export Parity Price
S.N.
Step in the Calculation
Relevant step
Financial Price 1
CIF at point of import
CIF - Birgung 2
Deduct unloading at point of import, fright to point of import and insurance
Fright, insurance and handling 3
Equals FOB at point of export
FOB port 4
Convert foreign currency into domestic currency at official exchange rate
Convert at official exchange rate 5
Deduct export duties
Export duties 6
Deduct local port charges
Port handling 7
Deduct local transport and marketing costs from project to point of export (if not part of project)
Freight to port 8
Equals export-parity price at project boundary (farm gate)
Export parity price – farm gate

10. Valuation of Non-tradable Goods and Services
Material Inputs
Domestic distortions may alter prices of the non-tradable goods,
Adjustment is necessary if the prices that enter into economic analysis are to reflect opportunity costs,
Shadow pricing of non-tradable material inputs depends on its total share on project benefits (cost) and sensitivity to NPV.

11. Valuation of Non-tradable Goods and Services
Land
Supply is totally inelastic
Use of indirect method to value land
Land price varies depending on different location specific variation
Land price: V = R (i – g) where, V = imputed value of parcel of land, R = annual “rent” or income from the land, i = interest rate or opportunity cost of capital and g = real growth rate of GDP
Assumption: demand for land is purely a function of its rental value.

12. Valuation of Non-tradable Goods and Services
Wage
If labor market functions smoothly, the wage actually paid is adequate for both financial and economic analysis,
Government interventions in the labor market (e.g. minimum wage legislation, legal impediments to labor mobility) introduces distortions that make it necessary to use shadow wage rates to reflect the opportunity cost of using labor,
Shadow wage rate is not necessarily equal to the marginal output of labor,
If an economy with widespread unemployment, the project uses redundant labor, such a definition would lead to the conclusion that the shadow wage rate would be zero.
This definition ignores the fact that no one wants to work for free and there is some “reservation wage” below which people prefer being unemployed to taking a job.

13. Numeraire and Price Level
Choice of currency and price level
Financial analysis – currency of the country and prevailing market price
Economic analysis
Domestic currency at the domestic price level
Domestic currency at the border price level
Foreign currency at border price level

14. Numeraire and Price Level
Domestic currency at the domestic price level
Using the currency and price used in financial analysis
Domestic price is the price level used to (i) keep national accounts, (ii) reckon its taxes and expenditure, and (iii) use by business
Prices of traded goods and services are taken at “border price” and converted into domestic currency at a “shadow” exchange rate
Price of non-traded goods and services (e.g. cleaning service) are taken at their market prices.

15. Numeraire and Price Level
Domestic currency at the border price level
The prices of all imports and exports are taken at the border price and converted into domestic currency at prevailing market or official exchange rate
Price of non-traded goods and services (e.g. cleaning service) are converted to border price equivalent by means of a conversion factor
Foreign currency at border price
Price of imports and exports remain in foreign currency
Price of non-traded goods and services (e.g. cleaning service) are first converted to their border price equivalent by means of a conversion factor, and then to their foreign currency equivalent by means of the prevailing market or official exchange rate.

16. Numeraire and Price Level - Relationship
Category
Domestic market price
Border price
Economic cost in domestic currency at domestic price level
Economic cost in domestic currency at border price level
Economic cost in foreign currency at border price level 1 2 3 4 5 6
Imported goods
$ 140
$ 100
$ 125
$ 110
$100
Cleaning service
$ 50 -
$ 44
$ 40
Memorandum item
Official exchange rate
1.10
Shadow exchange rate
1.25
Conversion factor
0.88

17. Real Price, Nominal Price, and Inflation
Pn = [Pr x (IPC/100)] Where Pn = Nominal Price Pr = Real Price IPC = Price index (consumer price index, wholesale price index, other appropriate price index)

18. Constant Price and Real Price
Constant price and real price are used interchangeably, and referring to real price as constant prices is misleading,
Real price do not necessarily remain constant through time, but change in response to changes in the underlying conditions of demand and supply of goods,
Both real and relative prices change over time,
A single price estimate should not be given for an item throughout the life of the project,
When ever feasible and desirable, year by year changes in real prices should be incorporated in the cost and benefit streams,
The difficulties involved in forecasting prices are not to be underestimated,

19. Historical Price of Petroleum, Coffee and Copper Constant 1990 US dollars
Sector
1990
1991
1992
1993
1994
Petroleum ($/bbl)
21.2
17.0
16.3
14.6
13.9
Coffee ($/kg)
1.97
1.83
1.32
1.50
3.08
Copper ($/mt)
2,662
2,288
2,139
1,836
2,150

20. With and Without Comparisons
Irrespective of the nature of the project, its implementation reduces the supply of inputs and increase the supply of outputs available to the rest of the economy,
Examining the difference between the availability of inputs and outputs with and without the project is the basic method of identifying project costs and benefits,
It is not normally the same as a before/after comparison,
With and without comparison attempts to measure the incremental benefits arising from the project,
The before/after comparison, by contrast, fails to account for changes in production that would occur without the project and thus leads to an erroneous statement of the benefit attributable to the project investment.

21. With and Without Project Comparision

22. Displacement and Additional Effects
Sometimes a project competes with other projects and diverts demand away from existing projects
A hospital may provide services not only to people who otherwise would not have had access to health care, but also to patients who would have used existing facilities,
The benefit from the new hospital are overstated if the analyst counts as benefits the treatments received by all the patients visiting the hospital, rather than the incremental number of patients receiving treatment,

23. Displacement and Additional Effect

24. Identifying the Costs and Benefits
Projected financial revenues and costs are a good starting point for identifying economic benefits and costs,
Adjustments needed
Necessary to include (exclude) some costs and benefits
Revalue inputs and outputs at their social opportunity costs
Economic analysis looks at a project on the economy as a whole considering the opportunity costs for the country

25. Consumer Surplus
The difference between what consumers are prepared to pay for a product, and they actually pay,
Increase in consumer surplus should be treated as part of the benefits of the project,
A project may not only increase output, but also reduce the price of the output to consumers,
When a project lowers the price of the project’s output, more consumers have access to the same product and the old consumers pay a lower price for the same product,
Valuing the benefits at the new, lower price understates the project’s contribution to society welfare,

26. Measuring Consumer Surplus

27. Net Benefit Profile of a Project

28. Approaches of Converting Financial Prices to Economic Prices
Shadow Exchange Rate Approach:
Converting traded goods to domestic market prices to using SER. Willingness to pay numeraire
Standard Conversion Factor Approach:
Converting non-traded goods to border prices using conversion factors to reflect opportunity cost. Foreign Exchange Rate numeraire

29. Shadow Exchange Rate
Price expressed in foreign exchange is converted to domestic currencies using official exchange rate,
Official or event the market exchange rate may not reflect the economic value in units of domestic currency of a unit of foreign currency,
Trade policies (i.e. import duties, quantitative restrictions, export subsidies, export taxes) distort not only individual prices of goods, but also the price of foreign exchange for the economy as a whole,
Whenever serious trade distortions are present, border prices need to be converted into domestic currency equivalents using a shadow exchange rate, not the official or market exchange rate,
It is appropriate even if there are no balance of payments problems or if the official exchange rate is allowed to adjust freely,
Shadow exchange rate equals the market (or official) exchange rate only if all trade distortions such as import duties and export subsidies, are eliminated,

30. Estimation of Foreign Exchange Premium
SER = OERX (1+FEP) = OERX/SCF
SCF = 1/(1+FEP) = OERX/SER
Where
SER = Shadow Exchange Rate
OERX = Official Exchange Rate
FEP = Foreign Exchange Premium
SCF = Standard Conversion Factor

31. Calculating Shadow Exchange Rate
Category
Unit
Amount
Market exchange rate
NRs/$
95.00
Export, FOB
NRs. '000
17,677.00
Import, CIF
21,921.00
Import duties collected
3,703.00
Export duties collected
374.00
Import duties/ total imports %
16.89
Export duties/total export
2.12
Effective exhange rate
For exports Px
92.99
For imports Pm
111.05
Elasticity of supply of export
1.25
Elasticity of demand for imports
(1.00)
Weights
For Px (Wx)
0.50
For Pm (Wm)
Estimates of SER
102.02
Premium for foreign exchange
7.39%

32. Conversion Factor Method
Using international prices or border prices as indicators of opportunity cost,
Prices will be expressed in domestic currency using border prices,
Traded goods will be converted to border price using official exchange rate,
Non-traded goods will be converted into border prices using the a corrected factor called conversion factor,

33. Conversion Factor Conversion factor is
Ratio of (Economic Value/Financial Value) or
Ratio of (Border Price/Domestic Price)
Conversion factor is more convenient than economic price
Conversion factor can be applied directly to the financial data,
As long as the underlying tax and subsidy distortions remain unchanged in percentage terms relative to the price of the goods, conversion factors are unaffected by inflation,
As long as the underlying distortions remained unchanged, conversion factors calculated for one project can be applied to other projects in the same country

34. Food Export Company (Rs. ‘000)
Particulars
Financial Value
Economic Value
Conversion Factor
Inflow
Sales
1,800
Outflow
1,100
680
Unskilled labor
600
300
0.5
Skilled labor
100 80
0.8
Import materials
200
Transport service
Import component 60
Domestic component 40
0.4
Tax
Net benefit
690
1,120
Of which
Enterprise
Government
Employment
320
Domestic services 10

35. Steps for Adjustments: Financial Prices to Economic Prices
Adjustment for direct transfer payments
Omit the direct transfer such as following from financial analysis
Taxes, direct subsidies, credit transactions, loans, receipts, amortization, interest payment
Account payables and receivables
Adjustment of price distortions in traded goods
Traded items
Exports: FOB > Domestic cost of production (DCP)
Imports: DCP> CIF price
Border price
Export: FOB price
Import: CIF price
From border price to project site (gate price)
Import substitute good: Foreign exchange (FE) saved by using the domestic product valued at border price (CIF price)
Diverted exports: project uses items that might otherwise have been exported, then the opportunity cost to the society of thee items is the FE lost on the exports foregone valued at the border prices (FOB price)

36. Steps for Adjustments: Financial Prices to Economic Prices
Adjustment for price distortion for non-traded goods
Adjust prices of non-traded goods by using conversion factors
Non-traded items= CIF price > domestic cost of production> fob price or,
Non-traded because of government intervention by means of import bans, quotas, etc.
Usually bulky goods (bricks, etc.) cheaper to produce locally than to import and export price lower than domestic cost of production; or highly perishable goods (fresh vegetables or fluid milk)
Market prices are used as estimates of economic value when the market of the non-traded goods are close to perfect competition such as agricultural products.
Valuing land and labor (depending opportunity cost)

37. Steps for Adjustments: Financial Prices to Economic Prices
Tradable but not-traded:
Would usually be imported were it not for an import quota or an outright ban that is enforced against them:. Domestic price > World market price due to domestic protection.
If imported, its import price is much higher than domestic ones. Economic value is based on domestic market price [of the import item]
Goods under import ban, economic value is market price using willing to pay criterion assuming that the ban will be effective during the period of the project life.
Indirectly traded items - decompose the items
Value items by valuing domestic content as a nontraded item but the imported component as a traded item.

38. Steps for Adjustments: Financial Prices to Economic Prices
Economic export and import parity values
Prices for internationally traded commodities: forecasts published by WB and FAO. Other international organizations such as International Tea Committee, Cocoa, Coffee, etc. also publish price information for the products of their interest.
Financial export and import parity prices 
If project produces traded goods, use price projections made by international organizations as a base and adjust them to farm gate or project boundary prices.
If farm gate price is set administratively and is not allowed to adjust freely, then the administrative price should be used.
CIF or FOB adjustments

39. Steps for Adjustments: Financial Prices to Economic Prices
Economic value of a traded item-either an export or an import-at the farm gate or project boundary is its export or import parity value.
These values are derived by adjusting the CIF (cost, insurance, and freight) or fob (free on board) prices (converted to economic values) by all relevant charges (again converted to economic values) between farm gate or project boundary and the point where the CIF or fob price is quoted.
Both traded and non-traded goods must be valued simultaneously.

40. Domestic Resource Cost Coefficient
DRC is the board measure of comparative advantage of a good. It measures the
Cost of domestic and foreign inputs used in the production of a specific good at world prices,
Actual cost of achieving one unit of foreign exchange due to one unit production of a specific good,
Conservation of exchange rate due to production of specific good,
Compare the net cost of domestic resource which used in production of specific good relative to the total conserved foreign exchange in contrast with benefit-cost analysis that comparing real total cost respect to the profit,
Criterion to compare the production efficiency in domestic market relative to the world market and suggests that whether the specific good preferable to be produced in domestic market or imported,

41. Domestic Resource Cost Coefficient
The idea behind DRC is to compare the domestic cost of producing a certain good with its value added at international prices,
DRC can be expressed as
DRCj = (DCj/NVAj), where DCj = Domestic cost of production and NVAj = Value added at international prices
Comparing the DRC of different activity provide an inter-sectoral comparison of relative efficiency from which comparative advantage is derived,
According to the standard comparative advantage theory, in the absence of any distortions, like tariffs or exchange restrictions, the domestic cost can differ from international production cost because of technological factors or resource endowment

42. Home Assignment
Review the document on “Assessment of Education Project” and identify tradable and non-tradable inputs and outputs of the project?
Compute the import parity price for exporting 100 mt of maize?
Compute the export parity price of importing 100 mt of cement?