1. COST-BENEFIT ANALYSIS
Lecture Notes
ECON 437/837: ECONOMIC
COST-BENEFIT ANALYSIS
Lecture Two

2. PRINCIPLES UNDERLYING THE ECONOMIC ANALYSIS OF PROJECTS

3. Interface of Project with the Markets
Factor Markets → Project → Output Market
(Labor & Capital)
The role of microeconomics in project evaluation is to determine economic benefits or economic costs, which differ, more often than not, from financial benefits or financial Costs.

4. 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 $1,000 investment and NPV equals to $ Then the project uses $1,000 of resources and only produces $730 of value.

5. 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:
consumers valuation of an item may be greater than financial price they pay, e.g. road usage, water.
financial costs may not be the true costs, e.g. 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.

6. Commodity Specific Conversion Factors (CSCF)
Financial prices are market prices, which incorporate all the tariffs, taxes, and subsidies. These market distortions can often be combined and expressed as a proportional distortion D.
Where the combined rate of the
distortions D is expressed as a
proportion of the financial price

7. 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, Pd, (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.

8. Example of Financial and Economic Cashflows: the Case of Electricity Project
Table of Parameters for Financial Analysis
Price of Electricity
2.20
Rs/Kwh
Long term investment
Production of Electricity
1,500
Gwh/year
Machinery
8,000
Equipment
1,290
Gas
0.25
per Kwh
Financial Cost
Land
(Given as subsidy)
300
of Capital
12%
Coal
0.15
Cashflow: Financial Points of View (millions Rs.)
Year
2001
2002
2003
2004
2005
2006
Inflows
Sales
3300
Land (Subsidy)
Liquidation value of investment
Liquidation value of land
Total Inflows
Outflows
8000
1290
375
225
Labor Wages
120
Total Outflows
9,590
720
Net Cashflows
-9290
2580
-1283
Table of Parameters for Economic Analysis
Willingness to pay for electricity
3.00
Rs/Kwh
Economic Opportunity cost of Labor
80%
of financial wage bill
Foreign Exchange Premium
15%
Subsidy on Gas
30% of Financial Cost
Economic Opportunity cost of capital
10%
Resource flow: Economic Points of View (millions Rs.)
Year
CF*
2001
2002
2003
2004
2005
2006
Inflows
Sales
4500
4500
4500
4500
Land (Subsidy)
0.00
Liquidation value of land
1.00
300
Total Inflows
4500
4500
4500
4500
300
Outflows
Land
1.00
300
Long term investment
Machinery
1.15
9200
Equipment
1.15
1484
0.00
Gas**
1.50
560.63
560.6
560.6
560.6
Coal
1.15
258.75
258.8
258.8
258.8
Labor Wages
0.80 96 96 96 96
Total Outflows
10,984
915
915
915
915
Net Cashflows
-10984
3585
3585
3585
3585
300
566
*CF = Conversion Factors
**CF for gas = [(1.3)*(1.15)]/1 = 1.5

9. Three Postulates Underlying the Economic Evaluation Methodology
These postulates 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.

10. Economic Value of Local Calls for Rural Customers
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.
Economic Value of Local Calls for Rural Customers
Demand A Q0
P1 = 0.120 C
Data Traffic (minutes/ year) Q1
(MWTP)
P0 = 0.280
Tariff /Coping Cost (US$/minute)
Consumer Surplus (P1AC)
Payment for services
Economic value = Q0ACQ1 = Willingness to Pay

11. 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.
Suppliers will be indifferent between selling incremental units of the good at their supply prices and using the factors to produce other goods and services.
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.
Installation (Marginal Cost) of one more terminal and demand for rural telephone calls
Cost MC D2 D1 O Q0 Q1 Q2
Number of rural telephone calls

12. The implication of these postulates for the economic analysis of a project (Cont’d)
Third Postulate
Costs and benefits are added up without regard to who the gainers and losers are.
Focus on economic efficiency
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.
This approach attempts to separate the social aspects of project appraisal from the economic efficiency aspects.

13. Measuring Economic Benefits of a Project’s Output
Output from a project affects the market equilibrium. The changes in quantity demanded, quantity supplied and price translate into cost savings due to cuts in production of inefficient producers and an increase in consumption because of lowering of the market price.

14. Economic Benefits of Project Output (No Distortions)
Price S0
Economic Value
= WxsPs+WxdPd
If no output market distortions, then:
Ps = Pd = Pm A
S0 + Project C
P0m E G F
P1m B D D0
Quantity Q s1 Q0 d1 QT Q
Value of Resources Saved
Value of Increased Consumption
Financial benefit is P1m (Q1d-Q1s)
Economic benefit is Q1sGCQ0 + Q0CFQ1d

15. Measuring the Economic Costs of a Project’s Inputs
A project requires inputs for production. Demand of inputs by the project deprives some consumers in the market because of an increase in the market price. The rise in the market price invites additional investment in input markets, depriving funds for other sectors. These costs together constitute project’s gross economic costs.
Measuring the Economic Costs of a Project’s Inputs

16. Economic Costs of Project Input
(No Distortions) Q d 1 s S P m A B C
Units
Rand/Unit D
0+P
Value of postponed consumption
Value of additional resources

17. Small versus Large Changes in Prices
Often the quantity produced by a single project or purchased 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. Weights expressed in terms of elasticities:
Wxs =
Supply Elasticity 
Supply Elasticity - Demand Elasticity  -  =
Wxd =
Demand Elasticity 
Supply Elasticity - Demand Elasticity  - 
 = (defined positively) own price elasticity of supply
 = (defined negatively) own price elasticity of demand
Weights expressed in terms of elasticities:
Wxs
Wxd  -
These are long-run elasticities of demand and supply.
They are an average elasticity representing for the adjustments made by the market.

19. Calculating the Economic Value of Non-Tradable Goods
Economic Value = Wxs P s Wxd P d
= weighted average of supply (Ps) and demand (Pd) price
Where:
Ws + Wd = 1
If rationing then Ws = 0 and Wd = 1
Traded: Importable Ws = 1 and Wd = 0
Exportable Ws = 0 and Wd = 1
Non-traded Ws  0 and Wd  0
Three classes of goods: Ws Wd
2/3 1/3
1/2 1/2
1/3 2/3

20. 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.

21. 1. Sales Taxes Levied on Output of Project
Economic Benefit of an Output Supplied by a Project
--- when a tax is imposed on sales ---
Ws P0m + Wd P0m(1+t)
Economic Benefits
Value of Resources Saved
Value of Increased Consumption
Financial benefit is P1m (Q1d-Q1s) Economic benefit is Q1sCBB’A’Q1d
Example
Wx s =1/3, Wx d=2/3 Pm=120, tx =0.15
Pe = 1/3(120) + 2/3(120)(1+0.15) = 132
Pe = (1.15) = 132
Pd = Pm + T if unit tax
Pd = Pm(1+t) if ad valorem

22. 2. Subsidies on Production
Economic Benefits of a New Project
-- when a production subsidy is present --
Value of Resources Saved
Value of Increased Consumption
Financial benefit is P1m (Q1d-Q1s) Economic benefit is Q1sA’B’Q0+ Q0BCQ1d
Or if subsidy is proportion of total cost,
Example
Wxs =1/3, Wxd=2/3 Pm=120, K=0.40
Pe = 1/3(120/(1-0.40)) + 2/3(120) = 146
and

23. 3. Sales Taxes Levied on Input of Project
Economic Cost of an Input Demanded by a Project
--- when a tax is imposed on sales ---
Value of postponed consumption
Value of additional resources
Financial cost is P1d (Q1s-Q1d) Economic cost is Q1dC’B’ Q0 + Q0 BAQ1s
Example
Wxs = 0.25, Wxd = 0.75, P0 m = 90, t = 0.15
Pe = 0.25[90] [90(1+0.15)] = 100

24. 4. Production Input Subsidized
Economic Cost of an Input Demanded by a Project
--- when an input subsidy is present ---
Price S P E G F J B D Q d1 s 1
Quantity H A s1 m1 =
/ (1-k) m0 s0 d0
D0+Project S0 C I
After Subsidy D0
Value of Postponed Consumption
Value of Additional Resources
Financial Cost is P1m (Q1d-Q1s) Economic Cost is Q1dEFQ0 + Q0GHQ1S
Economic Costs
Wxs
+ Wxd P
m x0 P
(1-k)
Example
Wxs = 0.25, Wxd = 0.75, Pm = 90, k = 0.40
Pe = 0.25[90/(1-0.4)] (90) = 105

25. 5. Sales Tax and Production Subsidy on Input
Economic cost of a Project
-- When a production subsidy and a sales tax are present -- D0 Q0 E
Dn+P H Pz J G
Q2d
P0m
P0s=P0m/(1-kz)
S0+subsidy Dn
Q1s
Q1d Qz B C N A
P1m S0
P1s=P1m/(1-kz)
P0d=P0m (1+tz)
P1d=P1m (1+tz) M L U R
Value of additional resources
Value of postponed consumption
Financial Cost is P1m (Q1d-Q1s) Economic Cost is Q1dMGQ0 + Q0RLQ1s
Example
Wxs = 0.25, Wxd = P0m = 90, t = 0.15, k = 0.4
P1s = 90/(1-0.4) = 150 , P1d = 90(1+0.15) =103 , Pe = 0.25(150) (103) = 114

26. - Example of Electricity Supply by Thermal Generation -
Economic Value of Increase in Quantity Demanded of an Input in the Case of the Infinite Supply Elasticity
- Example of Electricity Supply by Thermal Generation -
Price Q0
Quantity
Ps=Pm
D0+P D0 Q1
Project demand (Q1 – Q0) of a non-tradable input
Ws = 1 and Wd = 0
If no direct subsidy then Ps = Pm

27. 6. Environmental Externalities
A Project with Pollution in the Lake
Financial benefit is P1m (Q1d-Q1s) Economic benefit is Q1sA’B’BCQ1d

28. Relationship between Market Prices and Demand and Supply Prices under Various Types of Distortions

29. 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.

30. 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.

31. 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.

32. 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 economic cost of employment 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.

33. Valuation of Non-Market Goods/Services
Revealed preference method: using the data obtained by observing the actual choices made by individuals in related markets.
State preference method: refer to direct survey approach to estimating the value placed on non-market goods or services.
E.g., apply to labor market: trade-off between higher wages and occupational risks of injury or death (value of life); apply to property market: house price related to location, amenity, noise.
Other notes:
Multipliers (w/o the projects, capital can be used elsewhere and have multiplier effects elsewhere – income/employment multipliers)
Secondary benefits (i.e., road projects: benefits by increased local business are already captured by traffic; other additional resource costs need to be captured)