1. The Economics Of Road Investment
John Hine
ETWTR
There are 3 main elements to this talk:
1) How are the benefits and costs of road construction calculated?
Benefits - what are the benefits to road construction
VOC savings
Development benefits (increased agricultural/industrial activity & generated traffic)
Costs - how do economic costs differ from financial costs
Labour
Equipment
2) What are the cost consequences of choice of technology?
Physical factors - utilisation, haul distances, labour productivity
Financial factors - wage rate, equip costs etc.
Economic factors - forex, employment
3) What are the wider implications for employment & development
Gov policy on employment
environment
women
& self sufficiency
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2. Questions and Decisions 1.
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 road be built?

3. Questions and Decisions 2.
Are complementary investments required?
Should stage construction be used?
What standards should be applied ?

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

5. The Costs of Road Investment
These include:
Supervision
Management
Manpower
Machinery
Materials
Land
Environmental Mitigation (e.g. Resettlement)
1) Management - This is particularly important in labour based works
2) Manpower - we will look at how we cost labour in construction projects
3) Machinery - even very labour intensive projects will have an element of equipment that needs costing.
4) Materials - gravels, concrete, wood etc.
5) Land - It maybe that land will need to be acquired for the road construction. All these items need to be included in an economic appraisal.
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6. Primary Effects 1. Reduced vehicle operating costs fuel and lubricants
vehicle maintenance
depreciation and interest
overheads
Reduced journey time
drivers, passengers and
goods

7. Primary Effects 2. Changes in road maintenance costs
Changes in accident rates
Increased travel
Environmental effects
Change in value of goods moved

8. Secondary Effects Changes in agricultural output Changes in services
Changes in industrial output
Changes in consumers behaviour
Changes in land values

9. Coverage and Double Counting
Any economic analysis should be designed to give maximum coverage of benefits.
But we must avoid double counting. Do not add primary and secondary benefits (e.g changes in land values added to changes in transport costs)
In a competitive economy the consumers’ surplus approach (used in HDM) should be adequate.

10. The Economic Comparison
An economic analysis involves a comparison of “With” and “Without” cases.
Traffic forecasts are made for BOTH scenarios - The analysis should not be based on “before and after”.
An unrealistic “Without” case can give a false result.
A range of “with investment” cases should be analysed to find the best solution. A minimum investment approach often gives the best economic results and should be tested.

11. Economic and Financial Prices
The cost to the economy of road rehabilitation and maintenance may differ from the financial cost because of :
taxes and duties
shortage of foreign exchange
under-employment
To reiterate what has already been said - the cost to the economy of road rehabilitation and maintenance may differ from financial costs because of:
1) Taxes and duties - important for costing equipment
2) A shortage of foreign exchange or overvalued currencies - adjustments need to be made because in the past international contractors may have appeared cheaper than domestic contractors. An economic analysis will show this to be false. Important for costing equipment.
3) Labour needs to be valued at its real cost - rural un or under employment may mean that the real cost of labour is below the wage rate for labour in the organised sector. The next slide will show how we deal with labour. Important for labour intensive works.
The Government will usually be concerned with ECONOMIC costs.
Contractors will usually be concerned with FINANCIAL costs.
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12. Use of Economic Prices
In an Economic Appraisal we use ECONOMIC (or SHADOW) prices NOT FINANCIAL prices
Adjust financial prices as follows:
Exclude all taxes and duties and subsidies
Use the planning discount rate not the financial market rate
If overvalued exchange rate then value
imports and exports more highly
Use the opportunity cost of labour
Standard Conversion Factors are now widely used for
road construction costs
An economist uses ECONOMIC/SHADOW/ACCOUNTING prices.
Interested in the impact of a project on the economy as a whole. For this reason we need to adjust financial prices to take out any distortions which affect the true market price of resources.
1) taxes and duties should be excluded but subsidies included. For example import duties imposed by government on the purchase of imported graders should be excluded from any calculations.
2) Planning discount rate should be used and not a financial rate. The planning discount rate can be obtained from the ministry of planning & finance etc.. The discount rate represents what the government sees as an acceptable return to capital. It will be the same in the roads sector as in forestry, health and education etc.
3) Where currencies have been overvalued, because of gov intervention, it may be necessary to value imports and exports more highly. This is not such a common problem now because of widespread economic adjustment programmes.
4) Of primary importance in labour intensive works is to value labour at its real value and not at an artificially set minimum wage.
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13. Benefits From Road Investment
Changes in transport costs occur because of :
Lower road roughness
Shorter trip distance
Faster speeds
Reduced chance of impassability
Reduced traffickability problems
Change in mode

14. Traffic Categories
Normal traffic: Existing traffic and growth that would occur on the same road, with and without the investment
Diverted traffic: Traffic diverted from another road to the project road as a result of the investment
Generated traffic: New traffic induced by the investment
Slide is self explanatory. Traffic is measured in person km, tonne km and/or vehicle km.
Normal traffic: Component of traffic where trip numbers and trip distances are same for “with” and “without” cases, but unit costs per vehicle km may be different.
Diverted traffic: Component of traffic that diverts to a cheaper route. Trip numbers are same for “with” and “without” cases but trip distances and unit costs per vehicle km will be different.
Generated traffic: Traffic component whereby entirely new trips are induced.
Note for the purposes of economic analysis “redistributed trips” (this is used in urban transportation modelling, it refers to trips where there is a change of destination as a result of investment) may be treated in the same way as diverted traffic.

15. Benefits from Road Investment
Transport cost savings for existing (or normal ) traffic
= Traffic x Change in Transport Costs per
km x distance
Main changes in cost from:
a) change in transport MODE
b) reduced journey TIME
c) reduced VOCs
Transport cost savings are calculated as:
Traffic * change in transport costs
In this context traffic includes headloading, bullock carts, camels, trucks, cars and buses.
The change in transport costs will be much greater if there is a change in transport mode from headloading to trucks.
Improved surface condition increases the speed of vehicles and therefore reduces journey times. The benefits come from value of time savings.
In a conventional appraisal the majority of benefits come from savings in vehicle operating costs with a change in road roughness.
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16. Generated Traffic Benefits
Traffic induced by the road investment are traditionally valued at:
Half the difference in transport costs
Hence total generated transport cost benefits
= Generated traffic volume x change in costs per km x distance x 1/2

17. Estimating Benefits
Normal traffic benefits: tripsN * d1 * (VOC1- VOC2)
Diverted traffic benefits: tripsD * ((d1 * VOC1)-(d2*VOC2))
Generated traffic benefits: tripsG * d2 * (VOC1- VOC2)/2
d1 = existing road length d2 new road length
VOC1 = vehicle operating costs per km “without”investment
VOC2 = vehicle operating costs per km “with” investment
VOC data relates to each road section and its condition at the time
1. Normal and generated traffic benefits are calculated in terms of the volume of traffic multiplied by the change in transport costs.
2. Generated traffic benefits are calculated in terms of traffic volumes multiplied by half the difference in transport costs. In economic theory the “half” represents the area under the downward sloping demand curve. Because the traffic is induced and is therefore new it cannot gain the full benefits of the change in costs. The “half” is a useful approximation. If the demand curve is strongly convex to the origin then the formula would overstate the benefits.

18. The Consumers’ Surplus Approach
Total
Benefits
Transport Cost Savings to existing
traffic and normal growth =
Cost +
Additional benefits from new
traffic and production induced
by new investment C1
1) Theory of the demand curve - with an improvement in the quality of a road:
Cost of transport goes down (C1 to C2)
demand for transport goes up (T1 to T2)
2) With road construction or road improvements there are benefits from
existing traffic
generated traffic
3) These total benefits are compared with the total costs of road construction.
If the benefits are greater than the costs the project in economically viable C2
T T Traffic
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19. Development Benefits
Development benefits arise from a combination of increased traffic and reduced transport costs.
Benefits may also include :
Increased agricultural production
Increased service provision
Increased industrial activity
Development benefits:
increased traffic using the road - through diversion etc.
increased economic activity because of the improved road
1) Increased agricultural production - reduced transport costs effectively increase fram gate prices and reduce the costs of inputs such as fertiliser. Higher farm gate prices may increase incentives to increase production.
2) Increased industrial/commercial activity - reduced transport costs may encourage industry to locate in particular locations
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20. Ethiopian Statistical Analysis

21. Illustration of Benefits
Headloading C1
Track
Costs
Improved
road C2 C3 T1
Traffic T2 T3

22. Different Types of Benefit
Normal traffic benefits
= traffic x change in transport costs
Development benefits
- A function of (change in transport costs)2
Social benefits
- A function of population x change in transport costs

23. Consumer’s Surplus Approach:
Advantages: Simple, cost based, traffic approach dependent on predicting changes in traffic
Disadvantages: May not address critical factors promoting either rural development or social access

24. Producers Surplus Approach
Advantages: Draws attention to changes in agricultural output (key economic activity in rural areas)
Disadvantages: No reliable way of predicting response
- impact studies give widely different answers
–it could be based on agricultural supply price
elasticities but this is almost never done; it requires
very careful examination to use.
For most projects benefits are just invented !

25. Producers’ Surplus p2 Increased p1 Price & Costs per unit Of output
farmgate price p1
lower input costs
O O2
Output

26. Indicies and Ranking
Widely used for feeder road planning; there are many different approaches
e.g. i) cost of improvement / population
ii) estimated trips / cost
Adavantages: Speed , simplicity, transparency, many factors can be incorporated
Disadvantages: How do we value widely different factors ? (adding up apples and pears); weightings are not stable ; cannot easily address questions of road standards, timing etc, ; possible double counting

27. Community Priorities
Community priorities now often form an important part of feeder road appraisal. It is possible just to ask communities to rank the investments they prefer- both within the road sector or between roads and other investments.
Advantages: Community acceptability, use of community knowledge
Disadvantages: Sectional interest groups may dominate voting, community knowledge of area or road impact may be poor

28. 1. Net Present Value: NPV = (B1- C1) + (B2- C2) + …
1. Net Present Value: NPV = (B1- C1) + (B2- C2) + ….. (Bn- Cn) (1 + r) (1 + r) (1 + r )n 2. Internal Rate of Return : solve for i, (IRR) = (B1- C1) + (B2- C2) + ….. (Bn- Cn) (1 + i) (1 + i) (1 + i )n B1, B2 … Bn : Benefits in years 1, 2 … n C1 C Cn : Costs in years 1, 2 …. n r : Planning discount rate , n : planning time horizon
Net Present Value. A positive value suggests the project is economically viable. The larger the NPV the better the project. NPV can be used to choose between mutually exclusive projects.
Internal Rate of Return. The IRR is a ratio. If the IRR is above the Planning discount rate the the project is economically viable. The higher the IRR the better the project but it cannot be used to decide between mutually exclusive projects (it would be wrong for a small project with a high IRR to displace a larger project with a lower IRR).
Both the NPV and IRR are easily used features of computer spreadsheets such as Excel and Lotus 123.

29. 3. Net Present Value/ Investment Cost NPV/ C = NPV/Ci
4. First Year Rate of Return
FYRR = (B1- C1) Ci
B1, C1 : Benefits and Costs in year 1.
Ci : Road investment costs
Net Present Value/Investment Cost (NPV/C) . This is mainly used to rank projects when there is a budget constraint. The higher the ratio the better the project. Projects are ranked in descending order of NPV/C and the highest ranked projects are accepted until the budget is exhausted. HDM-4 used the NPV/C as a ranking tool for the programme analysis. A form of incremental analysis is required if mutually exclusive projects need to be analysed within a budget constrained programme.
First Year Rate of Return (FYRR). This ratio is used as a simple indicator of optimal project timing. If the FYRR is less than the planning discount rate then the project should be postponed. If the FYRR is greater than the planning discount rate the the project may be close to being optimal. In fact the FYRR is an imperfect tool of project timing. It depends upon a range of assumptions including a monotonically increasing benefit function (i.e there are no dips or discontinuities), and complications can arise when the road investment is scheduled over a number of years. A more accurate solution solution is to compare differently phased sequences of projects using the NPV approach.

30. Internal Rate of Return

31. Economic Comparison of Alternatives
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
Alternatives NPV
Optimal Alternative: Highest NPV
Project

32. Ranking Projects by Economic Priority
When comparing the economic priority of different projects, a recommended economic indicator is the NPV per Investment ratio
Projects
Selected Alternative Overlay Reseal
Overlay
NPV/Investment
2.1
PRIORI TY

33. Economic Decision Criteria
NPV IRR NPV/C FYRR
Economic validity v. good v. good v. good poor
Mutually exclusive v. good poor good# poor
projects
Project timing fair## poor poor good
Project screening poor v. good good poor
/robustness
Use with budget fair ## poor v. good poor
constraint
# Need incremental analysis
## Needs continuous recalculations

34. Appraisals & Post Evaluations 1.
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.

35. Appraisals & Post Evaluations 2
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 !