1. 1 Fin650: Project Appraisal Lecture 9 Economic Appraisal of Projects

2. Analyzing economic costs and benefits in an existing market Evaluation of costs and benefits in distorted markets Direct estimation of demand curve Extrapolation and econometric estimation

3. Producer surplus Consumer surplus

4. The gross economic benefits from the consumption of the output from this industry are greater than the financial revenues received by the suppliers due to the consumer surplus enjoyed by the consumers of the output. Economic cost of producing the output is less than the financial revenues received by the suppliers due to the producer surplus enjoyed by the suppliers. 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.

5.  Valuing Project outputs Will depend on the nature of the market in which the output is traded.  Elastic demand, or a small project Use market price Quantity supplied by the project *market price  Perfectly inelastic supply Use average of before and after project prices, area under the demand curve in the range of change in project output.  How to find price after the project?

6. Analyzing the Economic Benefits of an Output Produced by a Project

7. Economic Benefits of a New Project in an Undistorted Market: Upward sloping supply (a large project) Analyzing the Economic Benefits of an Output Produced by a Project

8. Analyzing the Economic Benefit of an Output (subject to tax) Supplied by a Large Project

9. If the quantity demanded by the project is relatively small compared to the size of the market then there will only be a very small change in the market price. In such a situation and given that we are operating in an undistorted market, the gross financial cost to the project will be equal to the gross economic cost. A difference only arises when the change in the quantity demanded by the project is sufficiently large to have a large impact on the prevailing market price.

10.  If the quantity demanded by the project is large compared to the size of the market then there will only be a change in the market price.  Government purchasing land ◦ Purchase price, P 2 *(q-q 1) ◦ Economic costs  Land taken through eminent domain ◦ Economic costs

11. Economic Cost of an Input Demanded by a Project in an Undistorted Market: Inelastic supply Analyzing the Economic Cost of an Input Demanded by a Project

12. Economic Cost of an Input Demanded by a Project in an Undistorted Market: Upward sloping supply curve and a large Project Analyzing the Economic Cost of an Input Demanded by a Project

13.  Large project subject to purely revenue generating input tax  General principles: ◦ When a project reduces the quantity of input available for other people, use the willingness to pay (as indicated by the demand curve) as value ◦ When a project increases the quantity of input that the market must produce, use marginal cost for the value of the added input ◦ Tax is treated as transfer

14. Analyzing the Economic Cost of an Input (subject to tax) Demanded by a Project

15. A project uses large quantity of cements to build a bridge. Cements are subject to a Tk. 1/bag tax and 100 million bags will be used to build the bridge. As a result of the bridge, the price of cement including the tax, will rise to from Tk. 2 to Tk. 2.30 per bag and private consumers are expected to decrease their consumption by 20 million bags. What costs should be attached to this input?

16. Analyzing the Economic Cost of an Input (subject to taxes related to externalities) Demanded by a Project

17. 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.

18. If market or government failures distort the relevant product market, then project benefits are measured by the changes in social surplus resulting from the project plus net revenues generated by the project Monopoly ◦ As in the competitive case, the social surplus generated by the output produced and sold in the monopolist is represented graphically by the area between the demand schedule and the marginal cost curve that is to the left of the MR and MC curves

19. ◦ Social surplus above the price is received by the consumers and that below the price is captured by the producer. ◦ Monopolist is a part of the society; therefore benefits accruing to them count. ◦ Breaking the monopoly will increase social surplus;  Deadweight loss would disappear.  Consumers will capture a part of the monopolists producers surplus, viewed as transfer.

20. Valuation of Benefits in Distorted Markets

21.  Natural Monopoly Four policies 1. Allow monopoly, deadweight loss abc, monopoly profits=P m afg. 2. Regulate monopoly, set P R = AC, eliminates monopoly profits, transferring social surplus to persons using the road, expands output, reduces deadweight loss from area abc to area dec, society’s benefit adeb. 3. Require road authority to set P c, eliminates deadweight loss, price is less than AC, revenue no longer cover costs, subsidy would be required. 4. Free access, marginal costs exceed willingness to pay, deadweight loss chQ o, no toll revenue, entire construction and operation costs have to be subsidized.

22.  Information Asymmetry  Externalities Negative Externality  Too low price, too much output, deadweight loss  Impose tax t  Social accounting ledger Positive Externality  Too high price, too little output  Provide subsidy v  Social accounting ledger  Public goods Little or none will be produced, willingness to pay, optimal level of output of public goods

23. Valuation of benefits in Distorted Markets

25.  Purchase at below opportunity costs e.g. witnesses, commuting costs, lost labor  Hiring unemployed labor Five alternative measures of social cost of hiring unemployed labor  Zero opportunity costs, other productive work, value of leisure, value of time: P e, P c,P d, P d, P r. Opportunity cost should be non-zero  Budgetary expenditure, workers were willing to work for less, subtract producers surplus, transfer to the workers  Area cdL d L t  ½(P m +P r )(L’)  ½(P m )(L’), assumes P r to be zero  Purchases from a monopolist

26. Measuring Costs in Inefficient Markets

27.  The general rule In factor markets in which supply is taxed, direct expenditure outlays overestimate opportunity cost In factor markets in which supply is subsidized, direct expenditure outlays underestimate opportunity cost In factor markets exhibiting positive externalities of supply, expenditures overestimate opportunity costs In factor markets exhibiting negative externalities of supply, expenditures underestimate opportunity costs Opportunity cost equals direct expenditure in the factor market minus (plus) gains (losses) in social surplus Occurring in the factor market

28.  Trade effects of outputs ◦ Extra export ◦ Less imports ◦ A combination of the two  Trade effects of inputs ◦ More imports ◦ Less exports ◦ A combination of the two  Economic benefit of exported/importable output  Economic cost of imported/exportable input

31.  In project analysis we estimate change in social surplus to value impact of the program/project ◦ Need to know the shapes of the supply and demand curves  There are well functioning competitive markets, know only one point on the demand and supply curves, represented by the equilibrium

32.  Goods that are rarely traded in markets- health and safety, pollutions, access to scenic areas  Commodities that are traded in imperfect markets, monopoly, asymmetric information, and externalities

33. Estimating benefits and cost based on demonstration or pilot programs. Alternative evaluation designs: – Classical experimental design with or without baseline data – Simple before and after comparison – Non-experimental comparison with or without baseline data Limited applications: – Employment and training programs, people oriented service – A new dam, on a small scale, pilot basis cannot be done Advantages: – A bad idea can be abandoned – Needed adjustment in the program may be made Disadvantages: – May not readily translate into a large-scale program – Uncertainty concerning external validity

34.  Three possibilities  Knowing one point on the demand curve and its slope or elasticity.  Extrapolating from a few points, know a few points on the demand curve that can be used to predict another point of relevance to policy evaluation.  Econometric estimation with many observations, have a sufficient number different observations of prices and quantities.

35. Current refuse disposal is 2.6lbs per person per day and disposed off in containers of 20lbs Currently there is no charge on refuse collection Marginal social cost (collection + landfill costs) = 0.6/lb In new Delhi for each Rupee increase in price of refuse collection reduces wastes by 0.4 lb/p/d Assume a linear demand curve Evaluate impact of imposition of a fee of 0.05/lb, i.e. Tk. 1 for each container of 20lbs, MPC is less than MSC

36.  Linear demand curve  Slope or elasticity estimates from previous research Assuming α 0 = 2.60, α 1 = - 0.4  Estimating social surplus gain from charging for refuse disposal ◦ A graphical illustration Using a Slope Estimate

37. Social Surplus Gain from Refuse Fee

38. We have an estimate of price elasticity of demand from previous research ◦ ε d = α 1 p/q ◦ α 1 = ε d q/p ◦ ε d =-0.12 ◦ p = 0.81, and q = 2.62, α 1 = -0.40 Construction of a linear demand curve to measure changes in social surplus requires either a direct estimate of the slope itself or an estimate of the price elasticity of demand and the price and quantity at which the elasticity was estimated.

39.  Effect of a fare increase on bus ridership ◦ If the past fare increase of Tk. 1 resulted in 1000 fewer riders, then it may be reasonable to assume that a further increase of Tk.1 will have the same effect ◦ Assumed functional relationship between the outcome and the policy variable  Linear functional forms can produce very different predictions than constant-elasticity functional forms  Further we extrapolate from past experience, the more sensitive are our predictions to assumptions about functional form  Econometric estimation with many observations ◦ If many observations of quantities demanded at different prices are available, then it may be possible to use econometric techniques to estimate demand schedule

40. Government supply many goods that are also provided by the private sector, e.g. education Using price and quantity of an analogous private sector good to estimate the demand curve for a publicly provided good The market price of a comparable good in the private sector is an appropriate shadow price for a publicly provided good, if it equals the average amount that users of the publicly provided good will be willing to pay – Private and public goods must be comparable in quality of service and other important characteristics – Limitations: Using private sector revenues would underestimate benefits, because it omits consumer surplus

41. Using the market analogy method to value time saved – Bridge, highway improvement saves time – Wage rate – Limitations of wage rate Benefits, should be added to wages People work during travel Truck drivers work, to be counted, wage + benefit Taxes, After tax wage rate plus benefit Pleasure travel Dirty, dangerous jobs, unemployed

42.  Using Airbags in car would increase probability of survival in a accident from p to p + w.  Additional cost of an airbag is Tk.1,000  W=1/1000  Calculate value of life.

43.  One type of construction job has a 1/1000 greater chance of a fatal injury in a year than another type of construction job.  Suppose riskier job pays a salary that is Tk. 2000 higher than the safer job  Calculate value of life.

44.  Using the market analogy method to value life saved ◦ Foregone earnings method  Value of life saved equals the present value of future earnings ◦ Consumer purchase studies (p+w)V(Life) –Tk. 1000 = pV(life) (p+w)V(Life) - pV(life) = Tk. 1000 wV(life) = Tk. 1000 V(life) = Tk. 1000 /w, w =1/10,000 V(life) = Tk. 1000 /(1/10,000) = Tk. 10,000,000 ◦ Labor market studies (1/1000) V(life) = Tk. 2000 V(life) = Tk. 2 million

45. Shadow prices Project analysis in developing countries LMST accounting price method in practice Intermediate goods and asset valuation method Travel cost method Social discount rate

46. When a market does not exist or market failure leads to a divergence between market price and marginal social cost, analysts try to obtain estimates of what market price would be if the relevant good were traded in a perfect market. Such an estimate is called a shadow price Estimates of shadow prices when markets are missing – Examples: value of a unit of time, statistical life, or the (negative) value of a particular type of crime

47. Shadow Prices

49. Plug-Ins for Value of Travel Time Saved Shadow Prices

50. Plug-Ins for Value of Recreational Activities (in 1999 U.S. dollars) Shadow Prices

51. Plug-Ins for Value of Environmental Impact (in 1999 U.S. dollars) Shadow Prices

52.  Project Analysis in developing countries have much in common with Project Analysis in industrialized countries  The main distinguishing characteristic of Project Analysis in developing countries is the much grater emphasis on adjusting the market prices of project output and inputs so that they more accurately reflect their value to society ◦ Markets are more distorted in developing countries  Segmented labor market  Overvalued exchange rate  Tariffs, taxes, and import controls  Formal and informal credit markets ◦ Use shadow prices/accounting prices instead of market prices

53.  Developed by UNIDO, I.M.D Little and J.A. Mirrlees, synthesized by Lynn Squire and Herman G. van der Tak  The LMST methodology ◦ Use world prices as shadow price for all project inputs and outputs that are classified as tradable ◦ World prices are less distorted than domestic prices  Imported input valued at import price, CIF  Exported output valued at export price, FOB  Examples ◦ Steel plant ◦ Agricultural crop

54. Shadow pricing involves multiplying each market price by an accounting price ratio – APR for good i = accounting/shadow price of good i /market price of good i – Shadow price of good i = APR of good i *market price of good i – Small country assumption Shadow price of an imported input or an output that is an import substitute Shadow price of an export Shadow price of a non-tradable good (electricity)

55. CIF price * Exchange rate = World Price in domestic currency – Use shadow exchange rate, if there is a big difference between official and market exchange rates Accounting prices – CIF price: APR = 1 – Tariff : APR = 0 – Transport cost: APR = 0.5 – Distribution cost: APR = 0.8 – Weighted APR: 0.85 Shadow price= Market Price*APR

56. Accounting Price of an Imported Goo Accounting Price of an Imported Good

57. FOB Price Export tax is a transfer between foreign purchaser (no standing) and the government: APR= 1 Transport for export: APR= 0.5 Factory gate price: APR=1 Shadow price = 5180*1+70*0.5+1750*1 =Tk. 6965

58. Accounting Price for Export

59. LMST involves determining the equivalent value of non-tradables in world prices Breaking down the cost of inputs into traded, non-traded and labor components Multiply market price by applicable accounting price ratio – CIF prices: APR =1 – Domestic transfer (tariffs and taxes): APR = 0 – Labor: APR = 0.6 – Standard conversion factor: 0.80

60. Accounting Price for Electricity Valued or Marginal Cost of Supply (in thousands of pesos)

61. Semi-input-output analysis Consumption conversion factors Weighted average of accounting price ratios for a nationally representative market basket of goods Standard conversion factors SCF = (M+X)/[(M+ T m –S m )+(X-T x +S x )] Where M= Total value of imports(CIF) X = Total value of exports(FOB) T m = Total tariff on imports T x = Total taxes on exports S m = Total subsidies on imports S x = Total subsidies on exports Average value of SCF for different countries 0.8 (ranges between 0.59-0.96)

62.  Constant marginal costs up to capacity level, up to Q 1 and then completely inelastic  Whether the fixed supply is binding or not  If not binding (demand with the project within the elastic range), no change in market price. Would not affect the current consumers of electricity ◦ Would require additional input to produce additional electricity, use shadow cost method for non-tradables  If binding, (demand with the project is in the inelastic range), market price will increase. Current consumers lose surplus and producers gain surplus  Measured in market prices, the cost of electricity would equal [(P 1 +P 2 )/2](Q 1 -Q 2 )  To convert into shadow price equivalent, multiply the cost by the consumption conversion factor( weighted average of accounting price ratios for a nationally representative market basket of goods).

63. Shadow Pricing when Electricity is Completely Elastic and Inelastic

64.  Location of the project  Source of labor  Accounting price ratio of type j labor = Shadow price of type j labor/ the market wage for type j labor  Shadow price of foreign workers ◦ SW f = [h + (1-h)(CCF)](PW) ◦ Where PW is the project wage, h is the fraction of PW sent or taken home, and 1-h is the fraction spent domestically  Rural market wage ◦ RMW = 0.5($50) + 0.25($10) + 0.25($.15) = Tk. 31.25

65. How much current consumption society is willing to give up now in order to obtain a given increase in future Consumption? It is generally accepted that society’s choices, including the choice of weights be based on individuals’ choices Three unresolved issues – Whether market interest rates can be used to represent how individuals weigh future consumption relative to present consumption? – Whether to include unborn future generation in addition to individuals alive today? – Whether society attaches the same value to a unit of investment as to a unit of consumption Different assumptions will lead to choice of different discount rate

66.  Generally a low discount rate favors projects with highest total benefits, irrespective of when they occur, e.g. project C  Increasing the discount rate applies smaller weights to benefits or (costs) that occur further in the future and, therefore, weakens the case for projects with benefit that are back-end loaded (such as project C), strengthens the case for projects with benefit that are front-end loaded (such as project B).

67. NPV for Three Alternative Projects

68. ● As individuals, we prefer to consume immediate benefits to ones occurring in the future (marginal rate of time preference) ● We also face an opportunity cost of forgone interest when we spend money today rather than invest them for future use (marginal rate of return on private investment) ● In a perfectly competitive market: rate of return on private investment = the market interest rates = marginal rate of time preference (MRTP) ● The rate at which an individual makes marginal trade-offs is called an individuals MRTP Therefore, we may use the market interest rate as the social discount rate

69. Equality of MRTP and Market Interest Rate

70. Six potential discounting methods – Social discount rate equal to marginal rate of return on private investment, r z – Social discount rate equal to marginal rate of time preference, p z – Social discount rate equal to weighted average of p z, r z and i, where i is the government’s real long-term borrowing rate – Social discount rate is the shadow price of capital – A discount rate that declines over the time horizon of the project – A discount rate S G, based on the growth in real per capita consumption

71.  Using the marginal rate of return on private investment ◦ The government takes resources out of the private sector ◦ Society must receive a higher rate of return compared to the return in the private sector  Criticism ◦ Too high  Return on private sector investment incorporates a risk premium ◦ Government project might be financed by taxes, displaces consumption rather than investment ◦ Project may be financed by low cost foreign loans ◦ Private sector return may be high because of monopoly or negative externalities ◦ Government investment sometimes raises the private return on capital

72.  Using the marginal social rate of time preference, p z ◦ Numerical values of p z  Real after-tax return on savings, around 2 percent for the US economy  Criticisms ◦ Individuals have different MRTP ◦ How to aggregate such individual MRTP ◦ Market interest rate reflects MRTP of individuals currently alive  Using the weighted social opportunity cost of capital WSOC= ar z + bi + (1-a-b)p z ◦ Numerical Value, 3 percent for the US economy

73.  Social discount rate should be obtained by weighting r z and p z by the relative size of the relative contributions that investment and consumption would make toward funding the project s = ar z + (1-a)p z, where a = ΔI/(ΔI+ ΔC) and (1-a) = ΔC/(ΔI+ ΔC)  Savings are not very responsive to changes in the interest rate, ΔC is close to zero  The value of the parameter a is close to one  The marginal rate of return on private investment r z is a good approximation of true social discount rate

74. Criticisms of WSOC Criticisms applicable to use of r z and p z applies Different discount rates for different projects based on source of financing Use the shadow price of capital Strong theoretical appeal Discounting be done in four steps Costs and benefits in each period are divided into those that directly affect consumption and those affect investment Flows into and out of investment are multiplied by the shadow price of capital θ, to convert them into consumption equivalents Changes in consumption are added to changes in consumption equivalents Discounting the resultant flow by p z

75. Shadow price of capital Where r z is the net return on capital after depreciation, δ is the depreciation rate of capital, f is the fraction of gross return that is reinvested, and p z is the marginal social rate of time preference – Numerical values for the θ,SPC, 1.5-2.5 for the US economy – Applying SPC in practice Criticism of calculation and use of the SPC

76.  Using time-declining discount rates  Conclusion, social discounting in imperfect markets ◦ If all costs and benefits are measured as increments to consumption, use MSRTP, p z, Boardman et. Al. suggests a value of 2 percent, sensitivity 0-4 percent ◦ If all costs and benefits are measured as increments to private sector investment, use MRROI, r z, Boardman et. Al. suggests a value of 8 percent, sensitivity 6-10 percent ◦ If all costs and benefits are measured as increments to both consumption and private sector investment, use SPOC, θ, to increments in investment and then discount at MSRTP, Boardman et. Al. suggests for SPOC, a value of 1.65 percent, sensitivity 1.3-2.7 percent; and ΔI = 15 percent and, ΔC= 85 percent, in the absence of information

77.  Many government agencies do not discount at all  Shadow price of capital is rarely used  Governments do not use time-varying discount rates  Constant positive rate that varies from country to country ◦ US, 7-10 percent ◦ Canada, 10 percent, sensitivity 5-15 percent ◦ 0-3 percent for Health and Environment Projects  ADB, EIRR of 10-12 percent

78. Analyzing the Economic Benefits of an Output Produced by a Project

79. Economic Cost of an Input Demanded by a Project in an Undistorted Market: Elastic supply, large market or a small project

80. Valuation of benefits in Distorted Markets

81.  Intermediate good method ◦ If the output from a project is to be used as an input into the production of some other good, then the effects on profits of the other, downstream industry can be included as a benefit, e.g. irrigation, education and training, value added  Excludes consumer surplus  Double counting, demand curve for water, benefits to farmer  Asset valuation method ◦ Increase or decrease in the property value following implementation of a project, e.g. location of jail, park  Ex post CBA  Assumes other factors remaining the same  Not applicable in case of mobile assets

82. Used in valuing recreational sites Steps in travel cost method – Visitors from different origins bear different travel costs depending on their proximity to the site – The resulting differences in total cost, and the differences in the rates of visit that they induce provide a basis for estimating demand curve for the site – Select a random sample of households within the market area of the site – Survey the households to determine their number of visits to the site over some period of time, all of their costs involved in visiting the site, the cost of visiting substitute sites, their incomes, and their other characteristics – Specify a functional form for the demand schedule and estimate it using the survey data

83. Illustration of the Travel Cost Method

84. Travel Cost Method