WOLAITA SODO UNIVERSITY

College of Business and Economics

Department of Economics

Module for Microeconomics (I, II) and

Development Planning and Project Analysis II

Prepared by:

1. Ayana Anteneh (Assi. Professor)

2. Abayneh Ayiso (Lecturer)

Edited by:
 MARCH, 2023

WOLAITA SODO, ETHIOPIA

Table of Contents
MICROECONOMICS I 1
Introduction 2
1. Consumer Preferences and Choices 2
1.1. Consumer Preference 2
2. Approaches to Measure Utility 4
2.1.1. Assumptions of Cardinal Utility theory 4
2.1.2. Total and Marginal Utility 5
2.1.3. Law of diminishing marginal Utility (LDMU) 5
2.1.4 Equilibrium of a consumer 6
2.2. The Ordinal Utility Approach 8
2.2.1. Assumptions of Ordinal Utility theory 8
2.2.2. Indifference Set, Curve and Map 9
2.2.3. Properties of Indifference Curves: 10
2.2.4. The Marginal rate of substitution (MRS) 10
2.2.5. Special types of Indifference Curves 11
2.3. The Budget Line or the Price line 12
2.3.1. Factors Affecting the Budget Line 13
2.4. Optimum of the Consumer 15
2.4.1. Effects of Changes in Income and Prices on Consumer equilibrium 16
Questions 22
CHAPTER TWO 23
CHOICE INVOLVING RISK AND UNCERTAINTY 23
2.1. Introduction 23
2.2 Probabilities 23
2.3 Expected Utility (Expected Value) 23
2.4. Individual’s Preferences Towards Risk 25
2.5 Minimizing Risk 26
Questions 27
CHAPTER THREE: THEORY OF PRODUCTION 28
3.1 Introduction 28
3.2 Technological Relationship between Inputs and Output 28
3.3 Classification and Production Periods of the Variables 28
 3.4 Theory of Short Run Production 28
3.4.1 Production with a single variable input (Labor) 29
3.4.2 Stages of Production 30
3.4.3 The Law of Variable Proportion 30
3.5 The Long-Run Production Function 31
3.5.1 Returns to Scale 32
Questions 33
CHAPTER FOUR: THEORY OF COSTS 34
4.1 Cost Analysis 34
4.2 Short-run Cost Functions 35
4.3 Long-run costs 36
Questions 37
CHAPTER FIVE: PRICE AND OUT PUT DETERMNATION UNDER PERFECT COMPETTION 38
5.1 Perfectly Competitive market structure 38
5.2 Short run equilibrium of the firm 39
5.3 The long-run Equilibrium 40
Questions 41
CHAPTER SIX: PURE MONOPOLY 42
6.1 Introduction 42
6.2 Source and kinds of monopoly 42
6.3 Short run equilibrium under monopoly 42
6.4 Social costs of monopoly: the dead weight loss 43
Question 44
REFRENCES 45
MICROECONOMICS II 46
CHAPTER ONE: MONOPOLISTIC COMPETITION 47
1.1 Introduction 47
1.2 Assumption of Monopolistic Competition 47
1.3 Product Differentiation and Demand Curve 47
1.4 Demand and Revenue functions 48
1.5 Cost of monopolistic competition 48
1.6 The concept of product group and industry 48
1.7 Equilibrium Under Monopolistic Competition Short-run Equilibrium
49
ii
 1.8 Monopolistic Competition and Efficiency 51
1.9 Excess Capacity and Comparison with PC and Monopoly 51
Question 51
CHAPTER TWO: OLIGOPOLY 52
2.1 Introduction 52
2.2 Characteristics of Oligopoly 52
2.3 Causes of Oligopoly 52
2.4 Equilibrium of a firm 52
2.5 Classification of firms 53
Questions 61
CHAPTER 3: GAME THEORY 62
3.1 Introduction 62
3.2 Types of Games 62
3.3 The concept of Dominant Strategies 63
3.4 The Nash Equilibrium Concept 63
3.5 Mixed Strategy 64
3.6 Repeated Games 65
3.7 Sequential Game 65
3.8 Prisoners Dilemma 65
Question/s 66
CHAPTER FOUR  PRICING OF FACTORS OF PRODUCTION AND INCOME DISTRIBUTION 67
4.1 Introduction 67
4.2 Factor Pricing in A Perfectly Competitive Market 67
Questions 75
CHAPTER FIVE GENERAL EQUILIBRIUM ANALYSIS 76
5.1 Introduction 76
5.2 General Equilibrium Theory 76
5.2.1 General Equilibrium of Exchange and Production 76
5.2.2 General Equilibrium of Production 78
5.3 Derivation of Production Possibility frontier (PPF) 79
5.4 General Equilibrium of Production and Exchange and Pareto Optimality 79
5.5 Perfect Competition, Economic Efficiency, and Equity 80
5.6 Efficiency and Equity 81
Questions 81
iii
CHAPTER SIX INFORMATION ASYMETRY 83
6.1 Introduction 83
6.2 Properties of Information 83
6.3 Mixed Markets for Used Cars 83
Questions 85
REFERENCES 86
Development Planning and Project Analysis II 87
Course Description 85
Course Objective 85
Chapter One: Introduction: 87
An Overview of Project Analysis 87
1.1 The Project Concept 87
1.1.1 Definition of Project 87
1.1.2 Basic characteristics of a project 87
1.1.3 Classification of project 89
1.1.4 Why Project Planning? 91
1.1.5 Organic Link between Policy, Development Plan and Projects 92
1.1.6 The linkage between projects and programs 94
1.1.7 Uniqueness of Projects 95
1.2 The project Cycle 96
1.2.1 Identification (Opportunity studies) 98
1.2.2 Project preparation: Analysis and Appraisal phase 99
1.2.2.1 Pre-feasibility Study (Pre-selection/ Preliminary Screening) 99
1.2.2.2 Feasibility Study 101
Chapter Two: Financial Analysis and Appraisal of Projects 108
2.1. Scope and Rationale 108
2.1.1. When to undertake financial Analysis 108
2.2. Identification of Costs and Benefits 108
2.3. Classification of Costs and Benefits 110
2.3.1. Tangible costs and benefits of a project 110
2.3.1.1. Tangible costs of a project 110
2.3.1.2. Tangible Benefits 114
2.3.2. Intangible costs and Benefits 114
2.4. The valuation of financial costs and benefits 115
iv
 2.5. The cash flow in financial analysis 117
2.6. Investment Profitability Analysis 123
2.6.1. Non-discounted measures of project worth 123
2.6.2. Discounted measures of project worth 125
2.7. Sensitivity analysis 138
Chapter Three: Economic Analysis of Projects 139
3.1 An overview of economic analysis 139
3.2 Identification costs and benefits of economic analysis 144
3.2.1 Sunk cost 145
3.2.2 Transfer payments, externalities and others 145
3.3 Determining economic values 147
3.3.1 Adjustment for transfer payments 147
3.3.2 Shadow pricing 148
3.3.3 Traded and Non-Traded commodities 149
3.3.4 Valuation of Traded and Non-traded commodities 150
3.3.4.1 Valuation of Tradable commodities 150
3.4 Border parity pricing 151
3.5 National parameters and standard conversion factors 151
3.5.1 Conversion factors 151
3.5.2 The standard conversion factor 153
3.5.3 The Economic valuation of foreign Exchange: 154
3.5.4 valuation of non-traded goods 160
3.5.5 The valuation of primary factors of production: (Land, Labor, and Natural
Resources) 163
3.6 Social cost benefit analysis 166
3.7 Cost-effectiveness 167
3.7.1 Cost-effectiveness Analysis 169
3.7.2 Weighted Cost-Effectiveness 172
Chapter Four: Project Implementation, Monitoring and Evaluation 177
4.1 Introduction: What is Monitoring and Evaluation 177
4.2 Why monitoring and Evaluation 178
4.3 Different Kinds of Monitoring and Evaluation 179

v
 4.3.1 Internal and External Project M&E 179
4.3.2 Monitoring Levels 180
4.3.3 M&E and Stakeholder Participation 181
4.4 Procedures in Monitoring and Evaluation 181
Chapter Five: Evaluation: Some Basics of impact evaluation 187
5.1 Impact assessment basics 187
5.1.1 Qualitative versus quantitative impact Assessments 189
5.2 Methodologies in impact evaluation 190
5.2.1 Randomized evaluations 194
5.2.2 Matching Methods- Propensity score matching (PSM) 198
References 201

vi
WOLAITA SODO UNIVERSITY

DEPARTMENT OF ECONMICS

MICROECONOMICS I
(Econ2021)

MARCH, 2023 G.C

WOLAITA SODO UNIVERSITY

Introduction
Microeconomics deals with the behavior of individual economic units. Any individual or
entity such as consumers, workers, firms etc that play a role in the functioning of our
economy considered as an economic unit. Microeconomics explains how and why
these economic units make economic decisions. It also explains how consumers and
firms buy out puts and sale inputs and how their choices are affected by changing
prices/costs and incomes/revenues. Consumers, workers, firms etc are interested to
know causes of price and output instability as well as unemployment. Moreover, most
of our issues and problems are related to economic matters. In general, an individual
who does not understand basic economic principles will not appreciate and evaluate
public issues that are most of them are related with economics.
General Objective
After successful completion of this course, you will be able to analyze and interpret
economic behaviors of firms and households.

CHAPTER ONE
THEORY OF CONSUMER BEHAVIOR AND DEMAND
The theory of consumer choice lies on the assumption of the consumer being rational
to maximize level of satisfaction.
The consumer makes choices by comparing bundle of goods.
1. Consumer Preferences and Choices
In this section you will see how consumers allocate their limited income among
different number of goods and services.
Moreover, you will learn how consumer’s allocation decisions determine quantity
demand of goods and services.
1.1. Consumer Preference
Given any two consumption bundles (groups of goods) available for purchase, how a
consumer compares the goods?
Does he prefer one good to another, or does he indifferent between the two groups.
Strict (strong) preference
Given any two consumption bundles(X1, X2) and (Y1, Y2), if (X1, X2)>(Y1,Y2) or if he
chooses (X1,X2) when (Y1,Y2) is available, the consumer definitely wants the X-bundle
than Y.

2
Weak preference
Given any two consumption bundles(X1,X2) and (Y1,Y2),if the consumer is indifferent
between the two commodity bundles or if (X1,X2)  (Y1,Y2),the consumer would be
equally satisfied if he consumes (X1,X2) or (Y1,Y2).
Transitivity
It means that if a consumer prefers basket A to basket B and to basket C, then the
consumer also prefers A to C.
E.g. if consumption bundle (basket) which contains (x1, x2)> (y1, y2) and (y1, y2) > (z1, z2),
then it means that (x1,x2)> (z1,z2).
More is better than less
Consumers always prefer more of any good to less and they are never satisfied or
satiated. However, bad goods are not desirable and consumers will always prefer less
of them.
1.2 Utility
Economists use the term utility to describe the satisfaction or enjoyment derived from
the consumption of a good or service.
Definition

Utility is the level of satisfaction that is obtained by consuming a commodity or

undertaking an activity. In defining strict preference, we said that given any two
consumption bundles (X1, X2) and (Y1, Y2) the consumer definitely wants the X bundle
than the Y bundle if (X1, X2) > (Y1, Y2).
The concept of utility is characterized with the following properties:
 ‘Utility’ and ‘Usefulness” are not synonymous. For example, paintings by Picasso
may be useless functionally but offer great utility to art lovers.
 Utility is subjective. The utility of a product will vary from person to person. That
means, the utility that two individuals derive from consuming the same level of a
product may not be the same. For example, non-smokers do not derive any utility
from cigarettes.
 The utility of a product can be different at different places and time. For example,
the utility that we get from meat during fasting is not the same as any time else.

3
A Consumer considers the following points to get maximum utility or level of
satisfaction (factors which may affect a satisfaction a person obtains from consuming
a particular good or service):
How much satisfaction he gets from buying and then consuming an extra unit of
a good or service.
The price he pays to get the good.
The satisfaction he gets from consuming alternative products.
The prices of alternative goods and services.
2. Approaches to Measure Utility
There are two major approaches of measuring utility. These are Cardinal and ordinal
approaches.
2.1 The Cardinal Utility Theory
Neo-classical economists argued that utility is measurable like weight, height,
temperature and they suggested a unit of measurement of satisfaction called utils.
An util is a cardinal number like 1, 2, 3, etc simply attached to utility. Hence, utility can
be quantitatively measured.
Example: Suppose a consumer derived 5 utils of satisfaction from consuming the first
bread and 7 utils from the second bread. By how much is higher the second bread than
the first?

2.1.1. Assumptions of Cardinal Utility theory

1. Rationality of Consumers: The main objective of the consumer is to maximize
his/her satisfaction given his/her limited budget or income. Thus, in order to
maximize his/her satisfaction, the consumer has to be rational.
2. Utility is cardinally measurable: According to this approach, the utility or
satisfaction of each commodity is measurable. Money is the most convenient
measurement of utility. In other words, the monetary unit that the consumer is
prepared to pay for another unit of commodity measures utility or satisfaction.
3. Constant Marginal Utility of Money: According to assumption number two,
money is the most convenient measurement of utility. However, if the marginal
utility of money changes with the level of income (wealth) of the consumer, then
money cannot be considered as a measurement of utility.
4. Limited Money Income: The consumer has limited money income to spend on
4
 the goods and services he/she chooses to consume.
5. Diminishing Marginal Utility (DMU): The utility derived from each successive
units of a commodity diminishes. In other words, the marginal utility of a
commodity diminishes as the consumer acquires larger quantities of it. This law
is called LDMU.
6. The total utility of a basket of goods depends on the quantities of the individual
commodities: If there are n commodities in the bundle with quantities,
X 1 , X 2 ,... X n
the total utility is given by: TU=f ( X 1 , X 2 ...... X n
)

2.1.2. Total and Marginal Utility

Definitions
Total Utility (TU): It refers to the total amount of satisfaction a consumer gets from
consuming or possessing some specific quantities of a commodity at a particular time.
As the consumer consumes more of a good per time period, his/her total utility
increases. However, there is a saturation point for that commodity in which the
consumer will not be capable of enjoying any greater satisfaction from it.
Marginal Utility (MU): It refers to the additional utility obtained from consuming an
additional unit of a commodity. In other words, marginal utility is the change in total
utility resulting from the consumption of one or more unit of a product per unit of time.
Graphically, it is the slope of total utility. Mathematically, the formula for marginal utility
is:
TU
MU  Where, TU is the change in Total Utility, and,
Q
Q is change in the amount of product consumed.
2.1.3. Law of diminishing marginal Utility (LDMU)
Dear student, is the utility you get from consumption of the first orange is the same as
the second orange? The utility that a consumer gets by consuming a commodity for the
first time is not the same as the consumption of the good for the second, third, fourth,
etc.
The Law of Diminishing Marginal Utility States that as the quantity consumed of a
commodity increases per unit of time, the utility derived from each successive unit
decreases, consumption of all other commodities remaining constant. The LDMU is
best explained by the MU curve that is derived from the relationship between the TU and
5
total quantity consumed.

Table1.1 Hypothetical table showing TU and MU of consuming Oranges (X)

Units of
0 1st 2nd 3rd 4th 5th 6th
Quantity(x)
Unit Unit unit unit Unit Unit Unit
consumed
TUX 0 util 10 utils 16 utils 20 utils 22 utils 22 utils 20 utils
MUX 0 10 6 4 2 0 -2
A
MU TU

20
B
15 TUX

10

5
1 2 3 4 5 Quantity X

MUX
Fig.2.1Derivation of marginal utility from total utility
As the consumer consumes more of a good per time period,
o the total utility increases, at an increasing rate when the marginal utility is
increasing and
o increases at a decreasing rate when the marginal utility starts to decrease and
o Reaches maximum when the marginal utility is Zero.
The total utility curve reaches its pick point (Saturation point) at point A. This Saturation
point indicates that by consuming 5 oranges, the consumer attains its highest
satisfaction of 22 utils.
However, Consumption beyond this point results in Dissatisfaction, because consuming
the 6th and more orange brings a lesser additional utility than the previous orange.
Point B where the MU curve reaches its maximum point is called an inflexion point or
the point of Diminishing Marginal utility.

2.1.4 Equilibrium of a consumer

Single good consumption case: Diagrammatically,

6
 MUx
 At any point where point C like point A where MUX>Px, it pays the
1 A
consumer to consume more. At any point
below point C like C point B where
5
MUX<Px the consumer consumes less
of X. However, at point C where MUx=Px the
2 B
B
consumer is at equilibrium.
MUX
 Mathematically, the equilibrium condition
PX of a consumer that consumes a
2
single good X 5 1 occurs when the marginal
utility of X is equal to its market
Figure 2.2 marginal utility of a consumer
price. MU X
 PX
E.g. what amount of consumption of good X maximize utility of the consumer if utility
function of the consumer is estimated as U=2X2, with Px=8$?
Table 1.2 Utility schedules for a single commodity

Marginal utility
Quantity of Marginal utility
Total utility Marginal utility per Birr(price=2
Orange of money
birr)
0 0 - - 1
1 6 6 3 1
2 10 4 2 1
3 12 2 1 1
4 13 1 0.5 1
5 13 0 0 1
6 11 -2 -1 1
For consumption level lower than three quantities of oranges, since the marginal utility
of orange is higher than the price, the consumer can increase his/her utility by
consuming more quantities of oranges. On the other hand, for quantities higher than
three, since the marginal utility of orange is lower than the price, the consumer can
increase his/her utility by reducing its consumption of oranges.
Multiple good consumption case
A consumer that maximizes utility reaches his/her equilibrium position when allocation
of his/her expenditure is such that the last birr spent on each commodity yields the
same utility.
7
For example, if the consumer consumes a bundle of n commodities i.e x1,x2,…,xn, he/she
would be in equilibrium or utility is maximized if and only if:
MU MU MU
  .........   MU
X 1 X 2 X n

m
PX PX PX
1 2 n

Where: MUm –marginal utility of money (expenditure)

Table 1.3 Utility schedules for two commodities

Orange, Price=2birr Banana, Price=4birr

Quantity TUo MUo MUo/P Quantity TUB MUB MUB/P
0 0 - - 0 0 - -
1 6 6 3 1 6 6 1.5
2 10 4 2 2 22 16 4
3 12 2 1 3 32 10 2.5
4 13 1 0.5 4 40 8 2
5 13 0 0 5 45 5 1.25
6 11 -2 -1 6 48 3 0.75

Thus, suppose the income of the consumer is 20 birr, the consumer will be at
equilibrium when he consumes 2 quantities of oange and 4 quantities of banana,
MU MU 4 8
   2
orange
because banana

Porange Pbanana 2 4

Limitation of the Cardinalist approach

The Cardinalist approach involves the following three weaknesses:
1. The assumption of cardinal utility is doubtful because utility may not be
quantified.
2. Utility cannot be measured absolutely (objectively). The satisfaction obtained
from different commodities cannot be measured objectively.
3. The assumption of constant MU of money is unrealistic because as income
increases, the marginal utility of money changes.
2.2. The Ordinal Utility Approach
In the ordinal utility approach, utility cannot be measured absolutely but different
consumption bundles are ranked according to preferences.
The concept is based on the fact that it may not be possible for consumers to express
the utility of various commodities they consume in absolute terms, like, 1 util, 2 util, or 3
util, but it is always possible for the consumers to express the utility in relative terms.

8
It is practically possible for the consumers to rank commodities in the order of their
preference as 1 st 2
nd
3
rd
and so on.
2.2.1. Assumptions of Ordinal Utility theory
This approach is based on the following assumptions:
1. The Consumers are rational-they aim at maximizing their satisfaction or utility
given their income and market prices.
2. Utility is ordinal, i.e. utility is not absolutely (cardinally) measurable. Consumers
are required only to order or rank their preference for various bundles of
commodities.
3. Diminishing Marginal Rate of Substitution (MRS): The marginal rate of
substitution is the rate at which a consumer is willing to substitute one commodity
(x) for another commodity (y) so that his total satisfaction remains the same.
4. the total utility of the consumer depends on the quantities of the commodities
X 1 , X 2 ...... X
consumed, i.e., U=f ( n
)
5. Preferences are transitive or consistent: It is transitive in the senses that if the
consumer prefers market basket X to market basket Y, and prefers Y to Z, and then
the consumer also prefers X to Z.
The ordinal utility approach is expressed or explained with the help of indifference
curves. Since it uses ICs to study the consumer’s behavior, the ordinal utility theory is
also known as the Indifference Curve Analysis.
2.2.2. Indifference Set, Curve and Map
Indifference Set/ Schedule: It is a combination of different quantities of goods for
which the consumer is indifferent, preferring none of any others.
Table.1.4. Indifference Schedule
Bundle (Combination) A B C D
Meat (X) 1 2 4 7
Bread (Y) 10 6 3 1
Each combination of good X and Y gives the consumer equal level of total utility. Thus,
the individual is indifferent whether he consumes combination A, B, C or D.
Indifference Curves: An indifference curve shows the various combinations of two
goods that provide the consumer the same level of utility or satisfaction.
9
It is the locus of points (particular combinations or bundles of good), which yields the
same utility (level of satisfaction) to the consumer, so that the consumer is indifferent
as to the particular combination he/she consumes. By transforming the above
indifference schedule into graphical representation, we get an indifference curve.
Indifference curve Indifference map
10 A

Indifferenc
B e
6
bread (Y)

Good B
Curve (IC)
C
2 IC3
D IC2
1
IC1

1 2 4 7 Good A
Fig2.4 indifference curves and indifference map.
Meat (X)
Indifference Map: To describe a person’s preferences for all combinations bread and
meat, we can graph a set of indifference curves called an indifference map.
2.2.3. Properties of Indifference Curves:
Indifference curves have certain unique characteristics with which their foundation is
based.
1. Indifference curves have negative slope (downward sloping to the right).This is
because the consumption level of one commodity can be increased only by
reducing the consumption level of the other commodity.
2. Indifference curves do not intersect each other. Intersection between two
indifference curves is inconsistent with the reflection of indifference curves. If
they did, the point of their intersection would mean two different levels of
satisfaction, which is impossible.
3. A higher Indifference curve is always preferred to a lower one. The further away
from the origin an indifferent curve lies, the higher the level of utility it denotes:
Baskets of goods on a higher indifference curve are preferred by the rational
consumer, because they contain more of the two commodities than the lower
ones.
4. Indifference curves are convex to the origin. This implies that the slope of an
indifference curve decreases (in absolute terms) as we move along the curve
10
 from the left downwards to the right. This assumption implies that the
commodities can substitute one another at any point on an indifference curve, but
are not perfect substitutes.
5. Indifference curves cannot intersect each other.
6. By transitivity, the consumer must also be indifferent between points.
2.2.4. The Marginal rate of substitution (MRS)
Definition: Marginal rate of substitution of X for Y is defined as the number of units of
commodity Y that must be given up in exchange for an extra unit of commodity of X so
that the consumer maintains the same level of satisfaction.
Number of units of Y given up
MRS X ,Y

Number of units of X gained

It is the negative of the slope of an indifference curve at any point of any two
commodities such as X and Y, and is given by the slope of the tangent at that point:
i.e., Slope of indifference curve
y
 MRS
x
X ,Y

The diminishing slope of the indifference curve means the willingness to substitute X
for Y diminishes as one move down the curve. MRS is negative. However, we multiply by
negative one and express MRS X ,Y
as a positive value.

In the above case the consumer is willing to forgo 4 units of Banana to obtain 1 more
unit of Orange. Marginal Utility and Marginal rate of Substitution

Y 4 It is also possible to show the derivation

MRS ( between po int s A and B   4
X
X ,Y
1
of the MRS using MU concepts.
The MRS X ,Y
is related to the MUx and the MUy is: MRS X ,Y

MU X

MU Y

2.2.5. Special types of Indifference Curves

Convexity or down ward sloping is among the characteristics of indifference curve and
this shape of indifference curve is for most goods. In this situation, we assume that two
commodities such as x and y can substitute one another to a certain extent but are not
perfect substitutes.

11
However, the shape of the indifference curve will be different if commodities have some
other unique relationship such as perfect substitution or complementary.
Here, are some of the ways in which indifference curves/maps might be used to reflect
preferences for three special cases.
I. Perfect substitutes: If two commodities are perfect substitutes (if they are essentially
the same), the indifference curve becomes a straight line with a negative slope. MRS for
perfect substitutes is constant. (Panel a)
IC3 IC1 IC2 IC3
IC2
IC1

Out dated
Right

IC3
Total

shoe

books
IC2
IC1

Panel a Mobil Panel b Left Panel c Food

Fig.2.6 Special cases of indifference curves
II. Perfect complements: If two commodities are perfect complements the indifference
curve takes the shape of a right angle. Suppose that an individual prefers to consume
left shoes (on the horizontal axis) and right shoes on the vertical axis in pairs. Additional
right or left shoes provide no more utility for him/her. MRS for perfect complements is
zero (both MRS XY
and MRS YX
is the same, i.e. zero).
III. A useless good: Panel C in the above figure shows an individual’s indifference curve
for food (on the horizontal axis) and an out-dated book, a useless good, (on the vertical
axis). Since they are totally useless, increasing purchases of out-dated books does not
increase utility. This person enjoys a higher level of utility only by getting additional food
consumption. For example, the vertical indifference curve IC 2
shows that utility will be
IC 2
as long as this person has some units of food no matter how many out dated
books he/she has.
2.3. The Budget Line or the Price line
Indifference curves only tell us about the consumer’s preferences for any two goods but
they cannot tell us which combinations of the two goods will be chosen or bought.
In reality, the consumer is constrained by his/her money income and prices of the two
commodities.
This constraint is often presented with the help of the budget line

12
The budget line is a line or graph indicating different combinations of two goods that a
consumer can buy with a given income at a given prices.
Assumptions for the use of the budget line

In order to draw the budget line facing the consumer, we consider the following assumptions:

1. there are only two goods, X and Y, bought in quantities X and Y;

2. each consumer is confronted with market determined prices, Px and Py, of good X and
good Y respectivley; and
3. the consumer has a known and fixed money income (M).
 By assuming that the consumer spends all his/her income on two goods (X and
Y), we can express the budget constraint as:
M  PX X  PY Y Where, PX=price of good X; PY=price of good Y;
X=quantity of good X; Y=quantity of good Y; M=consumer’s money
income
Suppose for example a household with 30 Birr per day to spend on Meat (X) at 5 Birr
each and bread (Y) at 2 Birr each. That is P X  5 , PY  2 , M  30 birr .
Therefore, our budget line equation will be:
5X  2Y  30

Table 1.6 Alternative purchase possibilities of the two goods

Consumption Alternatives A B C D E F
Kgs of Meat (X) 0 1 2 3 4 6
Units of bread(Y) 15 12.5 10 7.5 5 0
Total Expenditure 30 30 30 30 30 30
At alternative A, the consumer is using all of his /her income for good Y.
Mathematically it is the y-intercept (0, 15).
And at alternative F, the consumer is spending all his income for good X.
mathematically; it is the x-intercept (6, 0). We may present the income constraint
graphically by the budget line whose equation is derived from the budget
equation.
By rearranging the above equation we can derive the general equation of a budget line,
M
M PX = Vertical Intercept (Y-intercept), when X=0.
Y   X PY
PY PY

13
 PX
 = slope of the budget line (the ratio of the prices of the two goods)
PY

M/PY

M/P
Fig.1.7. Derivation of the Budget Line
 Pt A is attainable but not all of income is the consumer is exhaustively used.
 Pt B is unattainable within current income of the consumer.
Therefore, the budget line is the locus of combinations or bundle of goods that can be
purchased if the entire money income is spent.

2.3.1. Factors Affecting the Budget Line

Effects of changes in income

 Increase in income causes an upward shift of the budget line that allows the
consumer to buy more goods and services and decreases in income causes a
downward shift of the budget line that leads the consumer to buy less quantity of
the two goods for normal goods. The slope of the budget line (the ratio of the two
prices) does not change when income rises or falls.

Effects of Changes in Price of the commodities

Changes the prices of the commodities change the position and the slope of the budget
line. But, proportional increases or decreases in the price of the two commodities
(keeping income unchanged) do not change the slope of the budget line if it is in the
same direction.
Let us now consider the effects of each price changes on the budget line
o What would happen if price of x falls, while the price of good Y and money incme
remaining constant?
Y

14
 M/py A

Here Px ’<Px, hence M/Px<M/Px1

B B’ X M/Px M/Px '

Fig. 1.10 Effect of a decrease in price of x on the budget line

 Since the Y-intercept (M/Py) is constant, the consumer can purchase the same
amount of Y by spending the entire money income on Y regardless of the price of
X.
 We can see from the above figure that a decrease in the price of X, money
income and price of Y held constant, pivots the budget line out-ward, as from AB
to AB’.
What would happen if price of x rises, while the price of good Y and money incme remaining
constant?
What would happen if price of Y rises, while the price of good X and money incme remaining
constant?
 Since the X-intercept (M/Px) is constant, the consumer can purchase the same
amount of X by spending the entire money income on X regardless of the price of
Y. Fig.2.13 Effect of a fall in price of Y on the budget line
 Since Py decreases, M/Py increases thereby the budget line shifts outward.
On the other hand decline in Py and Px by the same amount result in the entire
outward shift of budget line in both axis without changing slope of the line and
Rise in Py and Px by the same amount result in the entire inward shift of budget
line in both axis without changing slope of the line.

2.4. Optimum of the Consumer

A rational consumer seeks to maximize his utility or satisfaction by spending his or her
income.
It maximizes the utility by trying to attain the highest possible indifference curve, given
the budget line. This occurs where an indifference curve is tangent to the budget line so
that the slope of the indifference curve ( MRS XY
) is equal to the slope of the budget line

15
( P X / PY ).

Thus, the condition for utility maximization, consumer optimization, or consumer

equilibrium occurs where the consumer spends all income (i.e. he/she is on the budget
line) and the slope of the indifference curve equals to the slope of the budget line
MRS XY
 P X / PY .
Graphically, the consumer optimum or equilibrium is depicted as follows:

Y A

B
E
IC4

C IC3

IC2
D
IC1

Figure 1.14 Consumer equilibrium

 This equilibrium occurs at the point of tangency between the highest possible
indifference curve and the budget line. Put differently, equilibrium is established at
the point where the slope of the budget line is equal to the slope of the indifference
curve.
 Mathematically, consumer optimum (equilibrium) is attained at the point where:
PX MU MU MU PX
MRS XY
 , But we know
X
 Y
 ....... MU X
PY  MU Y
P X ...,
X

PY PX PY MU Y
PY

Question
16
A consumer consuming two commodities X and Y has the following utility function
U  XY  2 X .If the price of the two commodities are 4 and 2 respectively and his/her
budget is birr 60.
a) Find the quantities of good X and Y which will maximize utility.

b) Find MRS X ,Y
at optimum.

2.4.1. Effects of Changes in Income and Prices on Consumer equilibrium

A. Changes In Income: Income Consumption Curve and the Engel Curve
In our previous discussion, we noted that an increase in the consumer’s income (all
other things held constant) results in an upward parallel shift of the budget line. This
allows the consumer to buy more of the two goods. And when the consumer’s income
falls, ceteris paribus, the budget line shifts downward, remaining parallel to the original
one.
If we connect all of the points representing equilibrium market baskets corresponding
to all possible levels of money income, the resulting curve is called the Income
consumption curve (ICC) or Income expansion curve (IEC).
The Income Consumption Curve is a curve joining the points of consumer optimum
(equilibrium) as income changes (ceteris paribus). Or, it is the locus of consumer
equilibrium points resulting when only the consumer’s income varies.
Commo

ICC
E3
E2
E1
Commodity X

Engle Curve
I3
Inco
me

I2
I1
X1 X2 X3 Commodity X
Figure 1.15 the income –consumption and Engel curve
From the Income Consumption Curve we can derive the Engle Curve. The Engle
curve is named after Ernest Engel, the German Statistician who pioneered studies of
family budgets and expenditure positions
17
 The Engle Curve is the relationship between the equilibrium quantity purchased of a
good and the level of income.
B. Changes in Price: Price Consumption Curve (PCC) and Individual Demand Curve
Here, we hold money income constant and let price change to analyze the effect on
consumer behavior.
The fall in the price of x will result in out ward shift of the budget line that makes
the consumer to buy more of good x.
If we connect all the points representing equilibrium market baskets corresponding
to each price of good X we get a curve called price-consumption curve.
The price-consumption curve is the locus of the utility-maximizing combinations of
products that result from variations in the price of one commodity when other
product prices, the money income and other factors are held constant.
We can derive the demand curve of an individual for a commodity from the price
consumption curve. Below is an illustration of deriving the demand curve when
price of commodity X decreases from Px 1 to Px 2 to Px 3 .
Commodity

PCC

Commodity X

Px1
Price of X

Px2
Individual
Px3 demand
curve

X1 X2 X3 Commodity X
Figure2.17 the PPC and derivation of the demand curve

2.4.1. Income and Substitution Effects

o Let us Consider the case of a price-decline:
First a decrease in price increases the consumer’s real income (purchasing power),
thus enhancing the ability to buy more goods and services to some extent. Second,
18
 a decrease in the price of a commodityinduces some consumers (the consumer) to
substitute it for others, which are now relatively expensive (higher price)
commodities.The 1st effect is known as the income effect, and the 2nd effect is
known as the substitution effect. The combined effect of the two is known as the
total effect (net effect).

Note that:
I/py1 X 1 X 3 =NE= Total (net) effect
X 1X 2 = SE=Substitution
I’/py1 effect
A B IC2 X X = IE=Income effect

C IC1

I
x1 x2 IE x3 I’/px2 I/px2
SE Px 1
NE

Figure2.18 Income and Substitution effect for a normal good

Suppose initially the income of the consumer is I1 , price of goodY is Py 1 , and Price of
I I
good X is Px 1 , we have the budget line with y-intercept and X-intercept . The
Py 1 Px 1

consumer’s equilibrium is point A that indicates the point of tangency between the
budget line and indifference curve IC 1
. As a result of a decrease in the price of X from
I I
Px 1 to Px 2 the budget line shifts outward with y-intercept & X-Intercept . The
Py 1 Px 2

consumer’s new equilibrium will be on point B.

The total change in the quantity purchased of commodity X from the 1st equilibrium
point at A to the second equilibrium point at B shows the Net effect or total effect of
the price decline (change).
The total effect of the price change can be conceptually decomposed into the
substitution effect and income effect.
19
The Substitution Effect
The substitution effect refers to the change in the quantity demanded of a
commodity resulting exclusively from a change in its price when the consumer’s real
income is held constant; thereby restricting the consumer’s reaction to the price
change to a movement along the original indifference curve.
Now, imagine that we decrease the consumer’s income by an amount just sufficient
to return to the same level of satisfaction enjoyed before the price decline.
Graphically, this is accomplished by drawing a fictitious (imaginary) line of attainable
combinations with a slope corresponding to new ratio of the product price Px 2 so
Py 1

that it is just tangent to the original indifference curve IC 1

The point of tangency is the imaginary point C (imaginary equilibrium). The

movement from point A to the imaginary intermediate equilibrium at point C, which
shows increase in consumption of X from X1 to X2 is the substitution effect.In other
words, the effect of a decrease in price encourages the consumer to increase
consumption of X than Y.
The Income Effect
o The income effect may be defined as the change in the quantity demanded of a
commodity exclusively associated with a change in real income.
o In figure 2.18, letting the consumer’s real income rise from its imaginary level
(defined by the line of attainable combinations tangent to point C) back to its true
level (defined by the line of attainable combinations tangent to point B) gives the
income effect. Thus, the income effect is indicated by the movement from the
imaginary equilibrium at point C to the actual new equilibrium at point B, the
increase in the quantity of X purchased from X2 to X3 is the income effect.
o This movement does not involve any change in prices
When we look at both the substitution and income effects, the magnitude of the
substitution effect is greater than that of the income effect. The reason is that:
 Most goods have suitable substitutes and when the price of good falls, the
quantity of the good purchased is likely to increase very much as consumers
substitute the now cheaper good for others.
Spending only a small fraction of his /her income, i.e. with the consumers purchasing
20
many goods and spending only a small fraction of their income on any one good, the
income effect of a price change of any one good is likely to be small.
Usually, the income and substitution effects reinforce one another i.e. they operate in
the same direction. The substitution effect is always positive. i.e. if the price of a good X
increases and real income is held constant, there will always be a decrease in the
consumption of good X, and vise versa. However, the income effect in most cases, one
would expect that increases in real income would result in increases in consumption of
a good. This is the case for so called Normal goods.
In short in the case of normal goods, the income effect and the substitution effect
operate in the same direction –they reinforce each other. But not all goods are normal.
Some goods are called inferior goods. For an inferior good, a decrease in the price of
the commodity causes the consumer to buy more of it (the substitution effect), but at
the same time the higher real income of the consumer tends to cause him to reduce
consumption of the commodity(the income effect).
We usually observe that the substitution effect still is the more powerful of the two;
even though the income effect works counter to the substitution effect, it does not
override it. Hence, the demand curve for inferior goods is still negatively sloped.
Let us consider the following diagram that shows the income, substitution and net
effect for an inferior commodity in the case of a decline in the price of good X.

Y KEY:
X1X3= NE=Net effect
X1X2= SE=Substitution effect
X2 X3= IE=Income effect
E3

IC2
E1
E2

X1 X3 X2 X
IE IC1
NE

SE

21
Numerical Example

Suppose that the consumer has a demand function for good X is given by
2
X  20  MP X

Originally his income is $ 200 per month and the price of the good is 5$ per killogram.

Therefore,his demand for good X will be 20 

200
2
 28 per month.
5

Suppose that the price of the good falls to 4 per kilogram.Therefore,the new demand at
200
the new price will be: 20  2
 32 . 5 per month.
4

Thus,the total change in demand is 4.5 that is 32.5-28.

When the price falls the purchasing power of the consumer changes.Hence,in order to
make the original consumption of good X,the consumer adjusts his income.This can be
calculated as follows:

M
1
 P1' X  P y Y
M  P1 X  P y Y

Subtracting the second equation from the first gives:-

M
1
M  X [ P1
'
 P1 ]
M  X P1

Therefore, new income to make the original consumption affordable when price falls to
4 is:
M  X P1
M  28 * [ 4  5 ]  28

Hence,the level of income necessary to keep purchasing power constant is

M
1
 M  M  200  28  172

The consumers new demand at the new price and income will be :

172
X ( 4 ,172 )  20  2
 30 . 75
4

22
 Therfore,the substitution efffect will be:

X  X ( 4 ,172 )  X ( 5 , 200 )  30 . 75  28  2 . 75

The income effect will be:

X ( 4 , 200 )  X ( 4 ,172 )  32 . 5  30 . 75  1 . 75

Since the result We obtained is positive we can conclude that the good is a normal good.

Questions
I. Choose the correct answer from the given alternatives!
1. What happen on budget line if the price of good/s changed?
A. The budget line shift to the right when the price of the goods grow up
B. The slope of budget line remain the same if the change in price is not
proportional
C. When the price of one good decreases, the budget line shifts to the right on
the side of the good
D. The intercept of the budget line remain the same even the price of the goods
changed
2. Why indifference curves do not intersect with each other?
A. Because they are at same satisfaction level
B. Their combination of goods are different but they offer equal utility
C. Since they are different give different utility to the consumer
D. Because of assumption of constant utility along ICs
3. are goods whose demand increases as price of a commodity
increases.
A. Giffen goods B. Normal goods C. Inferior goods D. complementary
goods
II. Workout
1. A consumer’s Utility function is given by: U(x, y) = 2X0.6Y0.4. If the consumer’s
income is Birr 900 and the price of X is Birr 8 per unit and the price of Y is Birr 12
per unit.
A. What is the utility maximizing level of X and Y?
B. What is the marginal rate of substitution x for y at equilibrium level?

23
 CHAPTER TWO
CHOICE INVOLVING RISK AND UNCERTAINTY
2.1. Introduction

Information on prices and income is known by the consumer (decision maker). But many of
the choice problems that the consumers face entail uncertainty about the possible
outcomes of income, price and other variables. Information is a key input in decision
making. Decision made under uncertainty of information involves some kind of risk.

Uncertainty: is a situation which can result in a number of outcomes but one is not sure as
to which outcome is to be materialized.

Risk: is a consequence that one has to face as a result of the variability of outcomes from
uncertain situation.

2.2 Probabilities
Even though you don’t know what the value of uncertain investment1 (for example investment
in stock) will be next year, you can still describe what it might be. In particular, suppose you
know that over the next year, one of three things will happen to your $100 investment:
• Its value could go up by 20 percent to $120 (outcome A).
• Its value could remain the same (outcome B).
• Its value could fall by 20 percent to $80 (outcome C).
For any lottery, the probabilities of the possible outcomes have two important properties:
1. The probability of any particular outcome is between 0 and 1.
2. The sum of the probabilities of all possible outcomes is equal to 1.
Utility Function under Uncertainty
If the consumer has reasonable preferences about consumption in different circumstances, a

24
utility function can be used to describe these preferences.
However, under conditions of uncertainty some additional structure, called probability, needs
to be added to the choice problem.
2.3Expected Utility (Expected Value)
Expected Value– is outcome expected on average. It is the weighted average of all possible
outcomes of an event (the weights being probabilities).
Example: Take an event that can result in two possible outcomes; X1 = Outcome 1and X2 =
Outcome 2. Let 1 is the probability of outcome 1 and  2 is the probability of outcome 2,
then the expected value (E(X) of the event is given by:

E(X) = 1 X1 +  2 X2.
Variability – refers to the extent to which the individual outcomes are likely to vary from their
expected value. We use variance or standard deviation to see the variation of individual
outcomes from their expected value.
n 2
̅
Variance = σ =
2
∑π (X - X )
i=1
i i

2 2 2 2
σ = π1[(X1-E(X)] + π2[(X2-E(X)] +…+ πn[(Xn-E(X)]
Suppose you are choosing between two part time sales jobs that have the same expected
income of 1500 birr.
 The first job is based entirely on commission; i.e., the income earned depends on how
much you sell. There are two equally likely payoffs for this job: 2000 birr for a
successful sales effort and1000 birr for one that is less successful.
 The second job is salaried. It is very likely (0.99 probabilities) that you will earn 1510 birr,
but there is 0.01 probability that the company will go out of business, in which case you
would earn 510 birr in separation pay.
Note that these two jobs have the same expected income:
For job 1: Expected Income = 0.5(2000 birr) + 0.5(1000 birr) = 1500 birr
For job 2: Expected Income = 0.99(1510 birr) + 0.01(510 birr) = 1500 birr
However, the variability of the two job offers is different. We measure variability by recognizing
that large differences between actual and expected payoffs (whether positive or negative)
imply greater risk.

25
The variability for the two jobs can be calculated by the using the formula for variance:
2 2 2
σ = π1[(X1-E(X)] + π2[(X2-E(X)]
2 2 2
Variancejob 1 = σ J1
= 0.5[2000-1500] + 0.01[1000-1500]
2 2
σ J1
= 0.5[500]2 + 0.01[-500] = 250,00
2 2 2
Variancejob 2 = σ J2
= 0.99[1510-1500] + 0.01[510-1500]
2 2
δ J2
= 0.99[10]2 + 0.01[-990] = 9900

We can also measure variability by using the standard deviation (SD) formula. SD is the
square root of variance.

2 2 2
SD = σ = σ = π1[(X1-E(X)] +π2[(X2-E(X)]

2 2 2
SDjob 1 = σj1 = π1[(X1-E(X)] +π2[(X2-E(X)] = σ j1= 250,00 = 500

2 2 2
SDjob 2 = σj2 = π1[(X1-E(X)] +π2[(X2-E(X)] = σ j2= 9900 = 99.5
Thus, job 1 entails higher risk because the variability associated with its payoffs are greater
than job 2 (i.e., 500 > 99.5). But, this does not mean that rational decision makers will
choose job 1 to job 2. The choice of alternatives with different risk levels depends on the
attitudes or preferences that individuals have towards risk.
2.4. Individual’s Preferences Towards Risk

a. Risk Aversion: is a tendency to prefer a given amount of income with certainty than taking
a gamble with high possible return and possible loss. For a risk-averse person the utility from a
given amount of income is greater than the expected utility from different levels of income
with similar expected value.
Now suppose the women currently has 20,000 birr and she is considering to take a new but
risky job that will increase her wealth to 30,000 if it succeeds but will reduce her wealth to
10,000 if it fails. Each success and failure has equal probability of 0.5. The level of utility
increases from 10 to 16 to 18 as income increases from 10,000 birr to 20,000 birr to 30,000
birr. However, note that her marginal utility is diminishing, falling from 10 to 6 when income
increases from 10,000 to 20,000 and falling from 6 to 2 when income increases from 20,000 to
30,000.
To evaluate the new job, she can calculate the expected value of the resulting income.
26
Because we are measuring value in terms of the women’s utility, me must calculate the
expected utility E(U) that she can obtain.
E(Utility) = 0.5 ×Utility of(10,000 birr) + 0.5×Uility of(30,00 birr)
= 0.5(10) + 0.5(18)
E(U) = 14
The women decides to take or not to take the new job by comparing the utility associated with
the original job (i,e., U(20)) with the expected utility of the new job (i.e., E(U)). The woman
prefers the original job to the new risky job because the expected utility of the new job (14) is
less than the utility from her original job. For a risk-averse consumer the utility of the expected
value of wealth, u(20), is greater than the expected utility of wealth, .5u(10)+.5u(30).
b. Risk Loving
A consumer is Risk Loving if he/she prefers a risk income to a certain income with the same
expected value. Risk loving is a situation where the utility from a given amount of wealth
(income) is less than the expected utility.
Let’s suppose that the utility of 10,000 birr will be 3, the utility from 20,000 birr will be 8 and the
utility from 30,000 birr will be 18. Marginal utility increases from 3 to 5 to 10 as income
increases from 10 to 20 to 30 thousands of birr.

1 u (10 )   2 u ( 30 )
The expected utility from the new job is E(U)= 10.5. The
1 1
E(U)=  3  (18 )
utility from the original job is U(20,000 birr)= 8.
2 2
Thus, 10.5
1 . 5 > 9  10 . 5 8 and the consumer prefers to take the new
risky job.

c. Risk Neutral
If a person is indifferent between a given amounts of wealth with certainty and uncertain
income with the same expected value the person is said to be risk neutral.
For instance, given the utility from income as: U(10)= 6, U(20) =12 and U(30) = 18, the risk
neutral consumer is will be indifferent between the original job and the new risky job. This
is because U(20,000 birr) = E(U). The expected utility from the new job is: 0.5U(10)*0.5U(30)
= 0.5*6 + 0.5*18= 3 + 9 =12.
d. Risk Premium
The risk premium is the amount of money that a risk-averse person would pay to avoid
taking a risk.
27
 2.5 Minimizing Risk
Four ways that consumers use to reduce risks are:
1. Diversification: Given that a consumer is a risk averse, he/she minimizes the risks of
uncertainty by diversifying his holding or assets.
2. Purchase of Insurance: Let’s imagine that you are risk averse and you have just
purchased a new car. You can minimize the risk by buying the insurance for your car.
Because a risk-averse decision maker prefers a sure thing to a lottery with the same
expected value, you will prefer to buy a fair insurance policy that provides full
coverage against a loss rather than buy no insurance at all.
3. Obtaining more information: If more information were available, consumers would
make better predictions and reduce risk.
4. Risk Spreading: In the absence of formal insurance, a group of individuals can agree
to share a loss incurred by each individual from their group.
Questions
I. Select the correct answer for the following questions
Based on the following information, answer the questions 1, 2 and 3
Suppose a man currently has 38,000 birr and he is considering taking a new but
risky job that will increases his wealth to 50,000 birr with likelihood of 0.6 if it
succeeds but will reduce his wealth to 20,000 birr with probability of 0.4 if it fails.
The utility level associated with 38,000 birr is 20 and the utility level associated
with an income of 20,000 birr and 50,000 birr is 15 and 30, respectively.
1. What is the expected utility of the new job?
A. 22.5 B. 26 C. 30 D. 24
2. What will be the type of risk?
A.      Risk Aversion C.      Risk Neutral
B.      Risk Premium D.      Risk Loving
3. Expected income of the new job is
A.     45,200 B. 23,200 C. 38,000 D. 35,000
4. is a consequence that one has to face as a result of the variability
of outcomes from uncertain situation.
Uncertainty B. Risk C. Variability D. Expected value

28
 CHAPTER THREE: THEORY OF PRODUCTION
3.1 Introduction
What is Production?
Production is the process of transforming inputs into outputs. Production is the process of
converting economic resources (inputs) into consumable forms (goods and services).
What is Production Function?
It describes the relationship between the amount of inputs and the amount of output that
can be obtained.
3.2Technological Relationship between Inputs and Output
It can be given as Q = f (labor, capital, natural resource, etc.)
Inputs are resources (raw materials or factors of production) used in the process of
production.
 Land. The economy’s NRs such as land, trees, and minerals.
 Labor. The mental and physical skills of individuals
 Capital. Goods-such as tools, machines, and factories-used in production.
 Entrepreneurship- is special talents of human being that helps to organize and
manage other factors of production like land, labor and capital.
 Q=f(L, K,…) , where L and K are the amount of labor and capital, respectively.
3.3Classification and Production Periods of the Variables
Inputs can be broadly divided into two: Fixed and variables inputs
Fixed inputs are inputs whose quantity cannot be easily varied over a short period of time
to change the level of output. Land, building, heavy machines, etc.. are examples of fixed
29
inputs.
Variable inputs are inputs that can be varied easily according to the desired level of output.
– E.g. Labour, raw material, etc…
Economists identify two periods of productions:
The short run: Is a period of time during which firms or producers can adjust production by
changing only variable factors but cannot change fixed factors.
The long run: Refers to a period of time, which is long enough to allow changes in the level
of all inputs. In the long run all inputs are variable and there are no fixed inputs.
3.4Theory of Short Run Production
Short run production theory tells us the relation between inputs and output when at least
one input is fixed. This relation can be shown by the concepts of Total, Marginal and
Average Products. Assume we have the following a short run production: Q = F(K, L)
Labor is the only variable input and K is fixed at some level.
Suppose that the production of maize require land, fertilizer, water machinery, etc.--, all
fixed at certain quantities. The only input the producer can adjust is labor. Thus, labor is
the only variable input. If labor input (measured in, say, worker/days) is 0, the output of
maize is, off course 0.
As we increases the variable input (labor input), the producer will increases the output of
maize. But, a point will come where increasing labor will not increase the output of wheat
at all and, in fact, might even decrease it.
3.4.1 Production with a single variable input (Labor)
Total Product (TP) is the total amount of efficiently utilizing specific and fixed input. The
total amount of output that can be produced by utilizing different quantities of L and fixed
is K.

Generally, the short run TP function follows a certain trend: It initially increases at an
increasing rate, then increases at a decreasing rate, reaches a maximum point and
eventually falls as the quantity of the variable input rises. This tells us what shape a total
product curve assumes.

Marginal Product (MP)

30
  It is the change in output attributed to the addition of one unit of the variable
input to the production process, other inputs being constant.

 or MP = dTP/dQ for functional form

 or MP = dTP/dQL for functional form. In other words, MPL

measures the slope curve of the total product at a given point.
In the short run, the marginal product of the variable input first increases, reaches its
maximum and then decreases to extent of being negative.
Average Product (MP)
Average product of an input is the level of output that each unit of input produces, on
the average. It tells us the mean contribution of each variable input to the total product.

Mathematically, it is the ratio of total output to the number of variable input.

If MP is positive then TP is increasing. If MP is negative then TP is decreasing.TP
reaches a maximum when MP=0 If MP > AP then AP is rising. If MP < AP then AP is
falling. When either MP=AP or slope of AP is zero, AP will be maximum. MP reaches
maximum if slope of MP is zero. I.e. dMP/dQL = 0.

3.4.2 Stages of Production

Based on MP behaviour, there are three stages of production:
Stage 1: Positive Marginal Returns: This stage of production covers the range of
variable input levels over which the average product (APL) continues to increase.
It goes from the origin to the point where the APL is maximum (where MPL=APL). This
stage is not an efficient region of production though the MP of variable input is positive.
The reason is that the variable input (the number of workers) is too small to efficiently
run the fixed input so that the fixed input is under-utilized (not efficiently utilized).
Stage 2: Diminishing Marginal Returns: Throughout this stage the average product (APL)
decreases Ranges over point where the APL is maximum until MPL is zero. MPL is
decreasing due to the scarcity of the fixed factor. That is, once the optimum capital-
labour combination is achieved, employment of additional unit of the variable input will
cause the output to increase at slower rate, thus, MP diminishes. This stage is efficient
region of production. Additional inputs contributing to TP and optimum utilization of
fixed input in the production. Hence, an efficient region of production is where the
marginal product of the variable input is declining but positive.
31
Stage 3: Negative Marginal Returns: Throughout this stage MPL is negative; aTPL is
decreasing. The volume of the variable inputs is quite excessive relative to the fixed
input;
 The fixed input is over-utilized and a rational firm should not operate in stage III.
3.4.3 The Law of Variable Proportion
The law states that the contribution of successive units of a variable input (labour) to
total output is eventually diminishing in the short run.

3.5 The Long-Run Production Function

In the long run, a firm has enough time to change the amount of all its inputs. All inputs
are variable.The long run production process is described by the concept of returns to
scale. Isoquants show combinations of two inputs that can produce the same level of
output.
Prosperities of isoquants
Isoquants have the same properties as indifference curves.
1. Isoquants slope down ward. Because isoquants denote efficient combination of
inputs that yield the same output, isoquants always have negative slope.
2. The further an isoquant lays away from the origin, the greater the level of output
it denotes. Higher isoquants (isoquants further from the origin) denote higher
combination of inputs and outputs.
3. Isoquants do not cross each other. This is because such intersections are
inconsistent with the definition of isoquants.
4. Standard isoquant curves are convex to the origin….due to diminishing marginal
rate of technical substitution
5. Isoquants must be thin. If isoquants are thick, some points on the isoquant will
become inefficient.
Isoquants can have different shapes (curvature) depending on the degree to which
inputs can substitute each other.
1-Linear isoquants
• Isoquants would be linear when labor and capital are perfect substitutes for each
other.
32
 • This case the slope of an isoquant is constant.
• As a result, the same output can be produced with only capital or only labor or an
infinite combination of both.
2. Input-output isoquants
• The isoquants are L-shaped. It is also called Leontief isoquant.
• This assumes strict complementarities or zero substitutability of factors of
production.
• In this case, it is impossible to make any substitution among inputs.
• Each level of output requires a specific combination of labor and capital.
3. Kinked isoquants
• This assumes limited substitution between inputs. Inputs can substitute each
other only at some points.
• The isoquant is kinked and there are only a few alternative combinations of
inputs to produce a given level of output.
• These isoquants are also called linear programming isoquants or activity
analysis isoquants.
Isocost lines represent all combinations of two inputs that a firm can purchase with the
same total cost.
C  w L  r K Where, C is total cost; w is wage rate of labour; r is cost of
capital.
C w
K   L
r r

33
Equilibrium is attained at MRTSLK = w/r, where the tangency point of isocost line and
isoquant curve. MRTSLK(slope of isoquant curve) = MPL/MPK; w/r(slope of isocost line).
The production function that generates linear Exp. Path keeping input price constant is
called Homothetic production function

3.5.1 Returns to Scale

• Constant returns to scale – a situation in which a proportional increase in all
inputs increases output in the same proportion
• Increasing returns to scale – a situation in which output increases in greater
proportion than input used.
• Decreasing returns to scale – a situation in which output increases less than
proportionally to input used.
If all inputs into the production process are doubled, three things can happen:
– output can more than double: increasing returns to scale (IRTS)
– output can exactly double: constant returns to scale (CRTS)
– output can less than double: decreasing returns to scale (DRTS)
Economists hypothesize that a firm’s long run production function may exhibit at first
increasing returns, then constant returns, and finally decreasing returns to scale.
Questions
I. Choose the correct answer
1. If Q = 3L + 6K, which of the following is false?
A. MRTS is a constant equal to ½ if L is on the horizontal axis
B. MPL = 3 units of output for each additional unit of L input
C. The production function displays constant returns to scale
D. K and L are perfect complements in production
E. K and L are perfect substitutes in production
2. When firm is producing in stage I,
A. MP is greater than AP C. Slope of AP curve is negative
B. The fixed input is over utilized D. a and b.
3. Considering short run production function, when MP rises
A. AP also rises C. TP declines
B. AP equals MP D. TP reaches maximum

34
 4. A firm’s marginal product of labor is 10 and its marginal product of capital is 40.
If the firm adds two unit of capital, but does not want its output quantity to
change, the firm should
A. Reduce its use of labor by 8 units. C. Reduce its use of labor by 2
units.
B. Maintain the same level of labor utilization. D. Also increase labor by 2 units.
II. Workout
1. Suppose a certain contractor wants to maximize profit from building drainage.
The contractor uses both labor and capital, and efficient combinations of labor
and capital that are sufficient to make drainage is given by the function: Q (L, K) =
2 L1/2 K1/2. If the prices of labor (w) and capital (r) are birr 10 and birr 20,
respectively, cost is birr 600.
a. Find the optimum combination of L and K

CHAPTER FOUR: THEORY OF COSTS

4.1 Cost Analysis
What are Costs?
To produce goods and services, firms need factors of production or simply inputs.
These factors of production are owned by households. To acquire inputs, they have to
buy them from resource suppliers. Cost is, therefore, the monetary value of inputs used
in the production of an item.
The cost of production is the sum of all payments made to the suppliers of inputs.
Inputs could be supplied by the owner of the business or owners of inputs. It can be
classified in to explicit and implicit costs.
Explicit (accounting) cost refers to actual expenditure/out of pocket
expenditure/monetary payment by the firm to outsiders for those who supply factors of
production.
35
Example: These are wage of workers, ccost of power (electricity and fuel), cost of raw
materials, and ect.
Implicit cost refers to the value of inputs owned by the firm and used by the firm in its
own production process.
Example: The owner can be the manager of the firm or the owner can use his/her own
building as a production place. Since these inputs are used for the purpose of producing
the item, their value has to be estimated. If a teacher quits his job and becomes the
manager of his/her own small farm.
Hence, economic cost is the summation of explicit and implicit costs.
 Accounting profit is total revenue minus explicit cost and economic profit is
total revenue minus economic cost (explicit + implicit cost)
 Normal profit is the minimum payment required to retain an entrepreneur in the
business.
 i.e. a firm is said to be earning normal profit, when its economic profit is zero.
That means, E∏ = TR- (ExC+ImC) 0= TR- ExC- ImC, since E∏ = 0, 0=A∏ - EC,
since TR- ExC = A∏ (accounting profit) A∏ = EC
 Thus, when the firm earns normal profit accounting profit is equal to (A∏) =
explicit cost (ExC)

4.2 Short-run Cost Functions

Total, Marginal, and Average Costs
In the short-run we have two types of inputs: fixed & variable inputs. So in the short run,
there are total fixed costs, total variable costs and total costs.
Total costs (TC) are equal to the sum of total fixed costs and total variable costs, i.e.
TC=TFC+TVC
Total fixed costs (TFC) are the costs that the firm incurs in the short run for its fixed
inputs; these are constant regardless of the level of output and of whether it produces
or not. An example of TFC is the rent that a producer must pay for the factory building
over the life of a lease.
Total Variable costs (TVC) are costs incurred by the firm for the variable inputs it uses.
Examples of TVC are raw material costs and some labor costs.

36
Average fixed cost (AFC) equals total fixed costs divided by output
 Average variable cost (AVC) equals total variable costs divided by output
 Average cost (AC) equals total costs divided by output
 AC also equals AFC plus AVC
 Average total cost tells us the cost of a typical unit of output if total cost is
divided evenly over all the units produced.
Marginal cost (MC) equals the change in TC or the change in TVC per unit change in
output
 Marginal cost tells us the increase in total cost that arises from producing an
additional unit of output.
Table 4.1 Total, Marginal and Average Costs in the Short-run

Output Q TFC TVC TC AFC AVC ATC MC

0 200 0 200 - - - -
1 200 50 250 200 50 250 50
2 200 90 290 100 45 145 40
3 200 120 320 66.7 40 106.7 30
4 200 140 340 50 35 85 20
5 200 150 350 40 30 70 10
6 200 156 356 33.3 26 59.6 6
7 200 175 375 28.6 25 53.6 19
8 200 208 408 25 26 51 33
9 200 270 470 22.2 30 52.2 62
10 200 350 550 20.0 35 55 80
When MC is below AC, AC will decline, when MC is above AC, the latter (AC) is rising,
and when MC is equal to AC, the latter will reach its minimum point.
The above relationship holds true for MC and AVC, i.e. when MC is below AVC, AVC will
decline, when MC is above AVC, the latter (AVC) is rising and when MC is equal to AVC,
the latter (AVC) will reach its minimum point.
AFC falls continuously because a constant total fixed cost is divided by increasing
outputs.
But the AC, AVC and MC curves are U- shaped.
The MC curve reaches its lowest point at a lower level of output than either the AVC
curve or the AC curve. The rising portion of the MC curve intersects the AVC and AC
curves at their minimum point.
The Relationship between production and costs
37
  Unit products and unit cost curves are mirror images of each other, i.e. For
instance, consider the relationship between AP and AC. When AP is rising AC is
falling; when AP is falling AC is rising; and when AP is maximum AC is minimum
 To illustrate this relation, assume a variable input labor (L) which commands a
wage rate w, TVC = w*L AVC = TVC/Q= w*L/Q = w/Q/L=w/APL
4.3 Long-run costs
The long-run is a period of time of such length that all inputs are variable.
If a production technology is characterized by constant return to scale (CRS), doubling
output requires doubling of input, which implies doubling of total output (cost) for given
factor prices.
The long-run total cost curve in this case is a straight line through the origin. This
implies that the long-run average and marginal costs are horizontal lines and equal (LAC
= LMC).
If we consider the case where total cost first increase at a decreasing rate due to
increasing returns to scale (which implies economies of scale).
Then at an increasing rate attributed to decreasing returns to scale after the optimum
size, the long-run total cost curve will not look like CRS total cost line.
The LAC and LMC curves will be U-shaped. In the long-run, the source of the U-shape is
increasing and decreasing returns to scale.
When the LAC is falling, then LMC < LAC. When LAC is rising, LMC > LAC. The two
curves intersect at a point where the LAC curve achieves its minimum.
When LRAC is declining we say that the firm is experiencing economies of scale.
Implies per-unit costs are falling. When LRAC is increasing we say that the firm is
experiencing diseconomies of scale. Per-unit costs are rising.
Questions
I. Choose the correct answer
1. If marginal cost is below average cost,
A. The slope of average cost will be negative C. Average cost increase
B. Average variable cost increase D. Average cost reaches its
minimum
2. If average fixed cost and total cost is 20 and 400, respectively, and then output
produced is 10 units, what will be the average variable cost of the firm?

38
 A. 200 B. 600 C. 20 D. 2
3. In a short-run production process, the slope of marginal cost curve is positive
and the average variable cost is declining as output is rising. Thus,
A. average fixed cost is constant
B. marginal cost is above average variable cost
C. marginal cost is below average variable cost
D. marginal cost is below average fixed cost

CHAPTER FIVE: PRICE AND OUT PUT DETERMNATION UNDER PERFECT

COMPETTION
The structure of a market is identified by referring to variables like, Number of seller and
buyer, Freedom of entry and exit out of the market; Control over price; Type of the
product traded and etc.

39
5.1 Perfectly Competitive market structure
Assumptions (A market is said to be PC, if the following assumptions hold true)
 Large number of sellers and buyers. Therefore the action of a single seller or
buyer can not influence the market price of the commodity, since the firm or (the
buyer) is too small in relation to the market.
 Products of the firms are homogeneous: uniform in terms of quantity, quality
and the services associated with sales and delivery are identical. i.e., products
are perfect substitutes for one another.
 Free entry and exit of firms
 The goal of all firms is profit maximization
 No government regulation: there are any discriminator taxes or subsidies, no
allocation of inputs by the procurement, or any kind of direct or indirect control.
 Perfect knowledge about market conditions: all sellers and buyers have a
complete knowledge: The price of the product, quality of the product, etc
Cost, Demand and Revenue functions under perfect competition
 AVC & AC have U –shape due to the law of variable proportions (in the short run)
and the law of returns to scale (in the long run).
 Under PC market structure large number of sellers selling homogenous products
and each seller is a price taker.
 If the seller charges higher price than the market price to get larger revenue, no
buyers will buy the product.
 Thus firms operating in a PC market sell any quantity demanded at the ongoing

40
 market price and buyers buy any amount they want at the ongoing market price.
Hence, the demand function that an individual seller faces is perfectly elastic (horizontal
line).
Total revenue of a firm operating under PC is given by the product of the market price
and the quantity of sales, i.e., TR = P*Q
Since the market price is constant at P*, the total revenue function is linear and the
amount of TR depends on the quantity of sales.  
MR and AR are equal under perfectly competitive market since price is constant.
MR = dTR/dQ= d(PQ)/dQ = P*dQ/dQ = P; AR= TR/Q = P*Q/Q = P
Hence, for firm operating under PC market, P = MR = AR
5.2Short run equilibrium of the firm
Under PC, the firm is said to be in equilibrium when it produces that level of output
which maximizes its profit, given the market price.
Short run equilibrium of the firm can be obtained in two ways:
Ì Total approach
Ì Marginal approach
1. Total Approach
 The profit maximizing level of output is that level of output at which the vertical
distance between the TR and TC curves are maxima. (Provided that the TR curve
lies above the TC curve at this point).
 The profit maximizing output level is Qe because it is at this output level that the
vertical distance between the TR and TC curves (or profit) is maximum.
2. Marginal Approach
The profit maximizing level of output is that level of output at which: MR=MC and given
MC is increasing (slope of MC is positive).This approach is directly derived from the
total approach.
 The slope of the TR curve constant and is equal to the MR or market price and
the slope of the TC is equal to MC.
 The distance between the TR and TC curves () is maximum when MR equals
MC.
In the short run, A PCM firm might be in one of the following three cases:
Case 1: Making Profit
41
If the ATC is below the market price at equilibrium, the firm earns a positive profit equal
to the area between the ATC curve and the price line up to the profit maximizing output.
MC
The firm earns a positive profit because price exceeds AC of production at equilibrium. AC

Case 2: Zero Profits

Costs
If the ATC is equal to the market price Revenu
e
at equilibrium, the firm gets zero.
MR=AR
The firm is making zero profits because
at the equilibrium level of output (Qe),
Average Cost is exactly equal to Average Revenue or Price.
Q
Case 3: Making Loss
If the ATC is above the market price at equilibrium, the firm earns a negative profit (incurs
a loss) equal to the area between the ATC curve and the price line. In this case, you may
ask that “why do the firm continue to produce if it had to incur a loss?” In fact, the firm will
continue to produce irrespective of the existing loss as far as the price is sufficient to
cover the average variable costs.
The short run supply curve of the firm and the industry
The word ’industry’ is defined as group of firms producing homogeneous products. Thus
the industry supply is the total supply or market supply.
The industry –supply curve is the horizontal summation of the supply curves of the
individual firms. The industry supply curve is obtained by adding the quantities supplied
by all the firms at each price. For example, at price which equals $ 6, firm 1 supplies 50
units, firm 2 supplies 80 units & firm 3 supplies 120 units. The market supply at $ 6 price
is thus 250 units (50+80+120 units).
The short run industry- supply is derived by repeating the above process at each price
levels.
5.3 The long-run Equilibrium
In the long run, firms are in equilibrium when they have adjusted their plant size so as to
produce at the minimum point of their long run AC curve, which is tangent to the
demand curve defined by the market price.
That is, the firm is in the long run equilibrium when the market price is equal to the
minimum long run AC.
First, if the firms existing in the market are making excess profits (the market price is
42
greater than their LACs) new firms will be attracted to the industry seeking for this
excess profit. He entry of new firms results in two consequences:
A. The entry of new firms will lead to a fall in market price of the commodity.
B. Moreover, the entry of new firms’ results in an upward shift of the cost curves due to
the increase of prices of factors as the industry expends.
Second, if the firms are incurring losses in the long run (P < LAC) they will leave the
industry (shut down).
Thus, due to the above two reasons, firms can make only a normal profit in the long run.
The condition for the long run equilibrium of the firm is that the long run marginal cost
(LMC) should be equal to the price and to the LAC i.e. LMC = LAC = P.
In the short-run the firm should continue production as far as the market price is greater
than the minimum AVC, If the market price falls below the minimum AVC, the firm is
well advised to shut down.
In long run the firm should shut down if its revenue is less than its avoidable or a
variable cost
An industry is in the long-run equilibrium when the price is reached at which all firms are
in equilibrium. That is, when all firms are producing at the minimum point of their LAC
curve and making just normal profits, the industry is said to be in the long-run
equilibrium.
Under these conditions there is no further entry or exit of firms in the industry (since all
the firms are getting only normal profit), so that the industry supply remains stable.
Questions
I. Choose the correct answer
1. Under perfectly competitive market, the firm is said to be in equilibrium when
A. Price is greater than marginal cost
B. Marginal cost is equal to marginal revenue and given marginal cost is
decreasing
C. The slope of total revenue curve is equal to market price
D. The distance between the total revenue and total curves is maxima when MR
exceeds MC.
2. Which of the following factor(s) lead to imperfect competition?
A. Existence of large number of sellers and buyers
43
 B. Perfect knowledge about market conditions
C. Price making
D. Production of homogeneous product

CHAPTER SIX: PURE MONOPOLY

6.1 Introduction
PM is the market structure in which there is only one firm that produces a distinctive
product (E.g. Ethiopian electric power corporation, ethio-telecom, water supply, etc).
By distinctive product we mean a product which has no close substitute. There is
considerable entry barrier for a new firm due to legal and patent rights, control over
essential raw material, technical, economies of scale, or any other. A pure monopoly
firm is a price setter, not price taker. Non-price competition is not necessary. Example:
pharmaceuticals with patents, regulated utilities (although this is changing), gas
stations, etc.
6.2 Source and kinds of monopoly
The fundamental cause of monopoly is barriers to entry of other firms in to the industry
The barriers to entry are therefore the sources of monopoly power. The major sources
of barriers to entry are legal restrictions- are created by law in public interest such
monopoly may be created in both public and private sectors, sole control over the
supply of key raw materials, efficiency and patent right.
6.3 Short run equilibrium under monopoly
Profit maximizing condition is MR=MC and MC is rising
If the monopolist raises the price of its good, consumers buy less of it. Look at another
way, if the monopolist reduces the quantity of output it sells, the price of output will
increases.
A Monopoly’s Marginal Revenue
• A monopolist’s marginal revenue is always less than the price of its good.
o The demand curve is downward sloping.
o When a monopoly drops the price to sell one more unit, the revenue received
from previously sold units also decreases.
Comparing Monopoly and Competition
44
 – For a competitive firm, price equals marginal cost. P = MR = MC
– For a monopoly firm, price exceeds marginal cost. P > MR = MC
– The monopolist will receive economic profits as long as price is greater than
average total cost.

Price Discrimination
Price discrimination is the business practice of selling the same good at different prices
to different customers, even though the costs for producing for the two customers are
the same. Price discrimination is not possible when a good is sold in a competitive
market since there are many firms all selling at the market price. In order to price
discriminate, the firm must have some market power.
Perfect Price Discrimination
– Perfect price discrimination refers to the situation when the monopolist
knows exactly the willingness to pay of each customer and can charge each
customer a different price. Examples of Price Discrimination: Movie tickets,
Airline prices, Discount coupons, Financial aid, Quantity discounts.
6.4 Social costs of monopoly: the dead weight loss
In a competitive market, price equals marginal cost of production. Monopoly power, on
the other hand, implies that price exceeds marginal cost. Because monopoly power
results in higher prices and lower quantities produced, we would expect it to make
consumers worse off and the firm better off. But suppose we value the welfare of
consumers the same as that of producers.
p

F
Dead
41 = pm D
weight
MC
A B Ec
Em
25 = pc
C
DD= Price = MR (for perfect competitor)
G Em
MR

0 Qm Qc Q
45
 6 10
Fig.6.8

Here, we use consumers’ and producers’ surplus as a measure of welfare of each.

Consumer surplus is the area between the demand curve and equilibrium price and
producer surplus is the area between the equilibrium price and marginal cost curve.
A perfect competitor’s equilibrium occurs when MC equal price or marginal revenue at
Ec and the equilibrium price and quantity are PC &QC respectively. Here the consumer’s
surplus is the area above the dropped line Pc Ec and below the demand curve i.e. area
of  Pc F Ec. On the other hand the producer surplus is the area below the dropped line
PcEc and above the MC curve.
A monopolist equilibrium occurs when MC = MR i.e. at Em and the equilibrium price and
quantity become Pm and Qm respectively. Hence, in monopoly lower quantity is sold at
higher price. The new consumers’ welfare is the area above the dropped line PmD and
below the demand curve (i.e. area of  PmFD) where as the producers surplus becomes
the area below the dropped line PmD and above MC curve to the left of Qm (i.e. the area
GPm DEm)
Thus monopoly power reduces the consumers’ surplus by the amount which equals
area A+B. But increase the producers’ surplus by the area A-C. The net welfare effect
(loss) is obtained by deducting the welfare loss of consumers from the welfare gain of
producers. i.e.
Net welfare = Welfare gain by producers – Welfare loss by consumers
= A-C – (A+B) = A-C – A-B = -C –B or – (C +B)
Thus, monopoly results in a welfare loss which is given by the area (C+B)
This area is called dead weight loss. It is gained neither by producers nor by consumers.
The other disadvantage (Social cost) of monopoly is that is discourages innovations.
Monopolist may feel secure and have no incentive to innovate new product (technology)
since there are no competitors.
Question
I. Choose the best answer
1. Which of the following factor(s) lead to imperfect competition?
a. Existence of large number of sellers and buyers

46
 b. Perfect knowledge about market conditions
c. Price making
d. Production of homogeneous product

REFRENCES
1. A. Koutsoyiannis, Modern Microeconomics
2. H.S. Agrawal, Principles of Economics, 7th edition.
3. Hal R. Varian, Intermediate Microeconomics: A Modern Approach, Forth Edition
4. C. Ferguson, Microeconomic Theory
5. R.S Pindyck and D.L.Rubinifeld, Microeconomics
6. E. Mansfield, Microeconomics: Theory and Applications
7. Robert H. Frank, Microeconomics and Behavior

47
WOLAITA SODO UNIVERSITY

DEPARTMENT OF ECONMICS

MICROECONOMICS II

(Econ2022)

48
 March, 2023 G.C
WOLAITA SODO UNIVERSITY

CHAPTER ONE: MONOPOLISTIC COMPETITION

1.1 Introduction
Monopolistic competition is a market structure in which many firms sell differentiated
products. Monopolistic competition was developed by Edward Chamberlin and Joan
Robinson in early 1930s. They were dissatisfied with the existing two extreme markets.
This market structure lies between the two extreme market structures of PC and
Monopoly. Both monopoly and perfect competition are rare to find. They don’t reflect
the true behavior of the majority of the firms. Examples: furniture, jewelry, leather goods,
barber shops, restaurants, books, magazines, films and movies, bottled water, etc.

1.2 Assumption of Monopolistic Competition

a. There are large numbers of sellers & buyers (but not as large as PC) in the product
group

b. Differentiated product and yet close substitutes: firms get certain monopoly power
to set price of their product. No identical or standardized product.

c. Ease of entry and exit: long run normal profit

d. Objective of the firms is profit maximization

e. Firms are assumed to behave as if they knew their demand and cost curves with
certainty

f. Heroic assumption: Both demand and cost curves for all products are uniform

49
 through the output group

g. The naive assumption: firms are assumed not to learn from their past experience.

1.3Product Differentiation and Demand Curve

Process of making a product appear different from other products. It is accomplished

by producing products that have distinct positive identities in consumers’ minds. The
goal of PD is to achieve market power. It changes the demand curve from horizontal to
downward demand curve.

Real product differentiation: products differ in terms of their inherent characteristics

such as inputs used, location, services etc. E.g. Shampoo with and without conditioner

Fancied (spurious) product differentiation: products are the same but producers
convince customers that their product is different. E.g. Differences which are created
due to advertisement, in packing, design, brand name and other sales promotion
activities.

E.g. Spring water( Yes Vs Abyssinia), Beer

1.4 Demand and Revenue functions

A firm gains certain monopoly power through product differentiation. This results in
downward sloping demand curve. Marginal revenue is also downward sloping but is
less than the demand curve. The firm did not loss its entire customer through price rise
even though some of them may switch to its competitors product. Small rise in price
results in large fall in quantity demanded. The demand curve is highly elastic, but not
perfectly elastic, because of the existence of large number of firms producing closely
substitute products. Flatter demand curve compared to pure monopolist and steeper
compared to perfect competitive firm.

When other things do not remain the same, the firm faces a new type of demand curve
called actual sales/market share/ demand curve.

1.5 Cost of monopolistic competition

Firms often devote considerable resources to differentiate their product from their
competitors through devices such as quality and style variations, warranty, special
services features, and product advertisement. The firm faces a new type of cost called
50
selling cost or cost of product differentiation. Average and marginal selling costs curve
of monopolistically competitive firm have U-shaped.

– Reason: economies and diseconomies of scale of selling activities.

• TC= Production Cost + Selling cost

The average and marginal selling cost of monopolistically competitive firm is generally
greater than that of perfect competitive and monopolist firm.

1.6 The concept of product group and industry

Industry: is collection of firms with identical product.

Product group: formed by lumping together firms producing similar products (but not
identical) which are close substitutes.

– They are group of products with higher price and cross elasticity of
demand.

Close substitution can be two types:

– Technological substitute: products which satisfy the same demand. e.g.

all motor cars i.e. they provide transport, TV, Computers

– Economic substitute: products which have similar price and satisfy the
same demand.

We do not have a single equilibrium price for differentiated product, but a cluster of
prices.

• Chamberlin assumed that every firm in the product group faces the same
demand curve with identical cost.

1.7 Equilibrium Under Monopolistic Competition

Short-run Equilibrium

At equilibrium, a firm should produce at a point where:

– MR = MC and

– Slope of MC is greater than that of MR

The firm charges the corresponding price (P) based on its demand curve. The nature of
51
profit earned at equilibrium depends on the relationship between P and AC. More
specifically,

– When P > AC, the firm earns an economic profit. (AR>AC)

– When P < AC, the firm incurs a loss.(AR<AC)

– When P = AC, the firm earns normal profit (AR=AC) i.e. profit=0

Three distinct model of long run equilibrium

A. Long run equilibrium with free entry of new firms ( there is no price competition
among the existing firms)

B. Long run equilibrium with price competition among the existing firms ( there is
optimal number of firms)

C. Long run equilibrium with price competition among the existing firms and free
entry of new firms(the ultimate solution)

Long run equilibrium with free entry of new firms

In this model

– the existing firms are assumed to be in the short run equilibrium realizing
abnormal profits;

– existing firms don’t have any incentive to adjust their price,

– but long run equilibrium is attained by new entrants who are attracted by
the lucrative (rewarding) profit margin

Long run equilibrium with price competition

Long run equilibrium with price competition among the existing firms ( there is
optimal number of firms)

This model assumes that the number of firms in the industry is optimal (no entry
or exit) and long run equilibrium is reached through price adjustment (price
competition) of the existing firms.

According to the model the firm can not learn from its past experience.

52
 A Long run equilibrium point

MR=LMC

LAC= P

Demand curve becomes tangent to the LAC curve

DD=dd=LAC; The market share demand curve passes through the tangency point
between perceived demand curve and LAC. Profit =0

1.8 Monopolistic Competition and Efficiency

In monopolistic competition, neither productive nor allocative efficiency occurs in long-

run equilibrium.

Productive Efficiency: is achieved when the output is produced at minimum average

total cost (ATC). Condition: P=min ATC

Allocative Efficiency: is achieved when the value consumers place on a good or service
53
(reflected in the price they are willing to pay) equals the cost of the resources used up in
production. Condition: P=MC

Since the firm’s profit-maximizing price (and average total cost) slightly exceed the
lowest average total cost, productive efficiency is not achieved.

Since the profit-maximizing price exceeds marginal cost, monopolistic competition

causes an under allocation of resources.

Monopolistic competition decision did not maximize social welfare since equilibrium
price is higher than MC and output is below social desired level.

1.9 Excess Capacity and Comparison with PC and Monopoly

Long run equilibrium of the firm under monopolistic competition is attained at a point
where the perceived demand curve is tangent to LAC curve. Compared to the LR
equilibrium of perfectly competitive firm, a monopolistically competitive firm: Produces
smaller units of output, Charges higher price, Price is above marginal cost of production,
Operates on the falling part of the LAC curve( it is at the min point of the LAC curve of
PC).

Question

Consider  an actual  demand  curve  DD facing  a firm working  under  monopolistic 

competition is given by P = 25-2Q  and  firms LAC = Q2 – 22Q + 125. Find equilibrium Q
& P.

CHAPTER TWO: OLIGOPOLY

2.1Introduction

Oligopoly is a market structure in which a few firms dominate the supply of an

industry’s output and compete with each other for markets. The main difference b/n
oligopoly and other markets is the existence of strategic interdependence of firms. In
perfect competition and pure monopoly price and output decision of one firm do not

54
affect other firms decision. In oligopoly it affects decision of the other firm.

2.2Characteristics of Oligopoly

Few number of firms in a given industry: The limiting case of oligopoly market is
where there are only two firms and this is called duopoly.

Firms produce homogenous or differentiated product

Interdependence of firms in decision making

Firms have some power to set price

Firms have profit maximizing objective. Example (domestic firms like Beer industry,
sealed water industry,…

Entry is difficult

2.3Causes of Oligopoly

Economies of scale: only few firms reach minimum of LAC, firms with minimum LAC
hinder entrances.

Barriers to entry: Only strong firms successfully pass all the barriers inter the market.
Collusion (merger of small firms): Merging of firms create few powerful firms and
others removed from the market.

2.4Equilibrium of a firm

There is no standard equilibrium solution in this market.

Two basic categories: Collusive models and non collusive models

2.5Classification of firms

Based on the reaction pattern, firms an be classified into

A. Non collusive models

Each firm makes decision independently by making some assumption about its
competitors decision. No contractual agreement and cooperation in making optimal

55
decision

Non-collusive oligopoly models include: Kinked demand model, Cournot’s duopoly

model, Bertrand’s duopoly model and Stackelberg’s duopoly model.

B. Collusive Oligopoly

Firms have implicit or explicit agreement in making optimal decisions. why collusion?

Collusion increases profit, decreases uncertainties, and can act as a barrier to entry of
new firms.

The models of collusive oligopoly are:

a. Cartel: Cartels aiming at joint profit maximization & Market sharing cartel

b. Price leadership: Price leadership by the low cost firm, Price leadership by the
dominant firm,& Barometric price leadership.

A. Non- collusive

The kinked demand curve model

Price in the other three markets rapidly adjusted to change in demand and supply.
Example if, for a normal goods, if income of the consumer increase  dd shift out  P
increase. If cost of production decreases supply curve shifts right ward and price
increases. But in in some oligopoly model price is sticky (stable) due to –
interdependency of decision and absence of agreement. The model assumes that once
equilibrium P is set at the intersection of actual and planned sale demand curves of
Chamberlin, firms are reluctant (unwilling) to change P. If it increases P slightly, others
will not follow a slight increase in P leads to high loss of market share (%ΔP<%ΔQ). So
planned demand (dd) is the elastic one. Therefore, the firm is unwilling to increase price
above equilibrium price.

If it decreases P others also do the same and leads to price war that decreases profit of
all firms, by decreasing P it actually sells less than the planned a decrease in P
increases sale by small amount (%ΔP>%ΔQ). So, thus its demand is the less elastic one
(DD). Since decrease in price decreases profit of all firms a firm is unwilling to decrease
P.

56
So the demand curve of a firm is kinked at equilibrium P, for above equilibrium P
planned demand curve and for below equilibrium P the actual demand curve. MR curve
is discontinues at the point of kinked. MC curve passes through the discontinuous gap.
Equilibrium is the kinked point even if MR is not cutting MC curve

• Critics: The model does not show equilibrium P is Set

Cournot Duopoly Model

Simple Cournot Model

Assumptions

• Two firms (A and B)

• Homogeneous product (mineral water)

• Equal (identical and constant) costs

• Naïve assumptions (firms do not learn from their past experience)

• Linear market demand curve

• Equilibrium price is set by the market

• Firms know that out put of one firm affects out put of the other through affecting
equilibrium P

57
A market share of n number of firms in the market is measured by 1/(1+n). Example1; if
total demand of market at zero price is 120 units and 5 firms are there in the market,
what is market share of each firm and how much does a firm supply?

Market share = 1+(1+5) = 1/6 Supply of each = 1/6*120 = 20

Cournot’s Reaction Curve Approach

Assumptions

• Two firms (A&B)

• Homogeneous Product

• Different cost

• Both firms are naïve and set equilibrium quantity simultaneously assuming out
put of the other is constant

• Equilibrium Price is set by the market

• Price set by amount of out put of A and B (Q=QA+QB=SS) i.e. Change in either of
QA or QB or both affect SS and change equilibrium P because P is set where
DD=SS

• Each firm, assuming maximum out put of the other is given, determine its out put
that maximize its profit ΠA=PQA - CA ΠB=PQB - CB

Example Firm A set QA assuming QB is maximum. If firm A expect that firm B will
decrease QB to QB0 , that affect profit of both firms, firm A can maintain its profit by
constant by increasing QA or decreasing QA. First firm A get ΠA from QA combined with
QB. If B decrease QB  SS decrease  P increase. So firm A can get the same profit
(ΠA). By producing less (QA0) at higher P or By producing more (QA1) that decrease P.

The curve along which the same amount of profit is derived from different combination
of quantity of both firms is called Isoprofit curve. On the other hand, firm A can react in
other way that increase or decrease its profit.

Properties of Isoprofot

1) Isoprofit of a firm for substitute goods is concave to the axis along which we
measure output of the firm
58
 2) Isoprofit that lie far from the axis along which we measure output of the firm
represent less profit

3) Assumption

The pick point (maximum point) of successive isoprofit for one firm lies to the right of
each other and the other is to the left of each other.

Reaction curve: is a locus of highest point of Isoprofit that tell us how much to produce
given the output of its competitor.

Equilibrium of both firms

• Equilibrium is where the reaction curve of both firms intersect.

• At the intersection point actual production of a firm and the out put estimated
(assumed) by the other firm are equal.

• At equilibrium profit of each firm maximized, but industry’s joint profit is not
maximized because of naïve assumption (they don’t learn from past experience)

• Had they learn from past experience they make agreement and can get the same
profit by producing less output on the contract curve

59
The Bertrand duopoly model

In Cournot model firms set their profit maximizing output and price set by the market. In
Berterend model firms set the profit maximizing price and how much they produce is
set by the market. So for Berterand the strategic variable upon which firms compete is
price.

Profit depends on the price charged π(P1,P2)

• If firm A charges less than firm B, it supply the entire market and B supply
nothing

• If firm A charges equal price with B, both supply half of the market

• If firm A charges higher price than firm B, firm A supply nothing and B supply the
entire market.

• Profit of A P1Y  C (Y )  
(P ,
1
p2 ) 
 [ PY

P1 0
 C ( Y )]

 C (0)  0
1
2

1
2

Equilibrium of the model

If one firm charges price higher than the equilibrium price there is always action and
reaction that leads to equilibrium.

Had they made agreement, they can get higher profit from the current out put by
charging higher price at the tangency point of higher isoprofit curves of the two firms.

Stackelberg Duopoly model

It is similar with cournot reaction curve approach. All the assumptions, isoprofit curves,
and reaction curves are the same except,

a) in this model one firm is naïve and follower, and the other is sophisticated and
leader

b) The leader knows every thing about the naïve and how the naïve react against its
60
 decision

c) So the leader set its equilibrium quantity on the most lower isoprofit curve
tangent to the reaction curve of the naïve firm.

d) Equilibrium decision is not simultaneously like Cournot but, sequentially. The

leader decide first and then the naïve make decision at the same point

The equilibrium is,

• On the most lower isoprofit that represent higher profit to the leader

• Tangent to the reaction curve of the naïve. If the equilibrium point is on the
reaction curve of the naïve firm, then since the naïve takes it as equilibrium it
does not react against the equilibrium

If both firms are sophisticated, both wants to be a leader to get higher profit. In this
case, market situation becomes unstable. Such situation is known as Stackleberg
disequilibrium. The instability continues until one surrender by price war or make
agreement to produce on the contract curve.

The leaders first determine the reaction function of its follower and then incorporate it
to its own profit function. Maximize its profit by setting marginal revenue equals to
marginal cost.

Example: Assume there are two firms producing homogeneous product and demand
equation is

P=60-2(y1+y2) and Cost of firm 1 is C1=y12 and cost of firm 2 is C2=4y2

a) Find Stackleberg equilibrium y1, y2, Y, P, π1, π2, Π if A is leader

b) Find Stackleberg equilibrium y1, y2, Y, P, π1, π2, Π if B is leader

Solution

a) y1=8, y2=10, Y=18, P=24, π1=128, π2=200 , Π=328

b) y1=5.5, y2=13.5, Y=19, P=22, π1=209, π2=90.75 , Π=299.75

B. Collusive Oligopoly

Collusion is the implicit or explicit (formal or informal)agreement between firms on

61
decision making.

Cartel

A cartel is a formal organization of firms producing the same product. Its objective is to
maximize the firms’ joint profit. The followings are examples of cartels.

a) Cartels aiming at joint profit maximization

b) Market sharing cartel

a) Cartels aiming at joint profit maximization

Member firms appoint a central agent that works to maximize the joint profit of the
cartel. Cartel knows about the cost of each firm and other information. Authority of the
central agency are to set equilibrium price, quantity and profit of the cartel, allocate the
output among firms and allocate the profit among the firms.

The central agency carryout its activities in this way: First estimate the cartel demand;
Derive the cartel marginal revenue (MR); Derive cartel marginal cost by summing up MC
of each firm i.e. MC=MC1+MC2; Equate the MR and MC and set equilibrium P, Q and
calculate profit of the cartel; Allocate the output and profit where MR=MC1, and
MR=MC2.

Assume demand function of a Cartel having two members is P=60-2Y and cost of firm 1
is C1=y12 and Cost of the second firm C2=4y2 MR =MC1=MC2

a) Find equilibrium y1, y2, Y, P,

b) Find equilibrium π1, π2, and π

Solution

a) y1=2, y2=12, Y=14, P=32

b) π1=, π2=, and π=396

b) Market Sharing Cartel

In such cartel firms make agreement on how to share the market

62
Non- price competition, Sharing of the market by agreement on quotas, Regional
sharing cartels

Price leadership

Price leadership agreement to cooperate is implicit without any formal discussion.

Firms enter in to such agreement voluntarily to avoid any uncertainty about the
competitor reaction.

a) Low cost price leadership

Assumptions

Two firms, homogeneous product, different costs, firms may have equal or unequal
market share. The low cost firm become leader and set price; The other follow taking
the price. If the follower refused to take the price the low cost firm eliminate through
price competition. But the follower firm can influence the price set by the leader
through supplying more or less than the expected amount. So the leader has to make
market share agreement formally or informally.

Thus, the leader set equilibrium price taking the market demand curve as its own and
make agreement with the follower how much to produce.

b) Dominant firm price leadership

Assumptions

There are few firms among which one is dominant; They supply homogeneous product;
The dominant firm knows market demand and MC of small firms.

The large (dominant firm), that supply more than the others set equilibrium price; Small
firms behave like prefect competitive firm and follow it.

 How does the dominant firm set equilibrium price?

The dominant firm estimate market demand function; Derives small firms SS curve by
summing up their MC. Equate market demand and small firms supply curve. Since small
firms act as perfectly competitive firm the leader compare P and summation of MC
(P=ΣMC). By decreasing price, it derives its demand curve (residual demand curve).
Residual DD = DD – small firms SS, Derive its MR; Set equilibrium P by equating its MR

63
and MC.

Example: Assume there are few firms supplying homogeneous product where there is
one dominant firm. If the estimated demand function of the market is D(P)=50-0.3p,
Small firms supply equation S(P)=0.2P, and the dominant firm cost function is C=2Y
then

a) Find the dominant firm residual demand curve equation, MR and MC

b) Set equilibrium quantity of dominant and equilibrium P

c) what is the total quantity demanded at equilibrium

d) Small firms supply at equilibrium

e) What is the profit of the dominant?

Solution

a) Y=D(P)-S(P)P=100-2Y MR=100-4Y MC=2

b) Y=24.5, P=51 c) D(P)=34.7 d) S(p)=10.2 e) π=1200.5

c) Barometric price leadership

A firm which have good knowledge of the prevailing condition in the market and can
forecast better than other about the future development in the market.

Questions

Choose the correct answer from the alternatives

1. All are models in collusive oligopoly market structure except one

A. Cartel C. Low cost firm price leadership. E.
None
B. Stackelberg duopoly model D. Dominant Firm price leadership
2. Which one is true about simple Cournot’s duopoly model?
A. There is identical cost between the firms. C. Heterogeneous products
B. The equilibrium quantity is set by market D. There is a leader and a
follower firm
3. Among the following identify correctly matched pairs of concepts
A. Oligopoly market – many sellers C. Monopolistic competition –
64
 homogeneous product
B. Dominant firm price leadership – set equilibrium price D. Duopoly – two
buyers
4. Market share cartel firms make contractual agreement on how to share market
through
A. Price competition C. Regional sharing cartels
B. Sharing of the market by agreement on quotas D. All except A

Workout

1. Assume demand function of a cournot duopoly firms given by P = 75-2Q and

cost of firm 1 is C1= 2Q1 2 + 25Q1 and Cost of the second firm C2 = 15Q2. Where
P, Q & C are price, quantity of the product and cost of the firms, respectively.
(Hint: Q = Q1 + Q2, C = C1 + C2)

A. Find equilibrium Q1, Q2 and P

B. Find equilibrium profit (π) of each firm

CHAPTER 3: GAME THEORY

3.1 Introduction

In the oligopoly market we noted that competition is intense. That is, firms must
consider the likely responses of competitors when they make strategic decisions about
price, advertising, & other variables.

In other words, the actions & reactions of a firm depend on the move & countermove of
the other firm just like a game.

Thus the development & application of game theory is one of the most exciting areas in
microeconomics.

Game is the science of strategic decision making. It is an action where there are two or
more mutually aware players & the outcome for each depends on the action of all. It is
65
also a situation where the participants’ payoffs depend not only on their decisions, but
also on their rivals’ decisions.

Four elements of a game:

 Players: Each decision maker in a game. These players can be individuals,

firms (as in the Oligopolistic markets), or entire nation (as in the military
conflict).

 strategies: when each player moves, what are the possible moves, what is
known to each player before moving; Strategy is a decision rule of players

 payoffs :The final return to the players of a game at its conclusion. How much
money each player receive for any specific outcome. E.g.. Payoffs for a firm
can be profit

 Rules: rules include whether the game is cooperative or noncooperative.

Players maximize individual gain or maximize their minimum return (risk
averse).

3.2 Types of Games

A game is cooperative if the players can negotiate binding contracts that allow them to
plan joint strategies. An example of a cooperative game is the bargaining between a
buyer and a seller over price of a commodity.

A game is non cooperative if negotiation & enforcement of a binding contract are not
possible. Example is a situation in which two competing firms take each other’s likely
behavior into account & independently determine a pricing or advertising strategy to win
market share

3.3 The concept of Dominant Strategies

Dominant Strategy: A strategy that yields a higher payoff than any other strategy, no
matter what strategy the other player follows. In any game each player has his own
strategy that enables him to win the game. That means the game’s likely outcome
depends on the strategy the player follows. Thus knowing the strategy help us to
determine how the rational behavior of each player will lead to an equilibrium solution.

66
A dominant strategy is a strategy that is optimal for a player no matter what an
opponent does.“I am doing the best I can no matter what you do.” “You are doing the
best you can no matter what I do.”

Payoff matrix of firms

We can observe from this payoff matrix that if both firms decide to advertise, firm A will
make profits of 10, and firm B will make profits of 5. If firm A advertises and firm B
doesn’t, firm A will earn 15, and firm B will earn zero. Dominant Strategy of firm B is to
Advertise; Dominant Strategy of firm A is also to Advertise.

Therefore, the equilibrium solution of the above game is (Firm A, Firm B) = (10, 5)

3.4 The Nash Equilibrium Concept

Equilibrium Concept: An equilibrium concept is a solution to a game. The equilibrium

concept identifies, out of the set of all possible strategies, the strategies that players
are actually likely to play. “ I am doing z best I can given what you are doing.” “You are
doing z best you can given what am doing.”

 Solving equilibrium is similar to making a prediction about how the game will be
played.

Nash equilibrium again is a set of strategies such that each player believes (correctly)
that it is doing the best it can, given the actions of its opponents. Since each player has
67
no incentive to deviate from its Nash strategy, the strategies are stable. In the example
shown in table above, the Nash equilibrium is that both firms advertise.

Two Nash equilibrium((top, left) & (bottom, right) are Nash equilibrium outcome))

Player B

Left Right
Player A
Top 1,2 0,0

Bottom 0,0 1,2

The are games without Nash equilibrium

Players Player B
Left Right
Player A Top 0,0 0,-1
Bottom 1,0 -1,3
3.5 Mixed Strategy

So far we have been thinking that each agent as choosing a strategy once and for all (a
one shot game) and sticking to it. This is called a pure strategy. On the other hand, if
agents are allowed to randomize their strategies, to assign probabilities to each choice
& to play their choice according to those prob. we call the strategy as mixed strategy.
Each player assign some predicted prob, to the strategy of the rival. Given these prob.,
player computes the expected payoffs.

Example : suppose palyer A (PA) expects player B(PB) to play left with a prob. of ‘q’ &
right with a prob of ‘1-q’.

Generally, PA expects PB to play a mixed strategy, (q, 1-q) &calculates the expected
payoff based on the prob. The expected payoff for PA: From playing top: 0(q) +0(1-q)=0
From playing bottom: 1(q) +-1(1-q)=2q-1

If the expected payoff from playing top=the expected payoff from bottom, PA will be
indifferent. 0=2q-1, q=1/2 If q>1/2, PA plays bottom, and If q<1/2, PA plays top

68
Similarly, let ‘r’ be z prob that PB expects PA to play ‘top’ & ‘1-r’ to play bottom. The
expected payoff for PB: From playing left: 0(r) +0(1-r)=0 From playing right: -1(r) +3(1-
r)=3-4r

If the expected payoff from playing left=the expected payoff from right, PB will be
indifferent. Hence, 0= 3-4r, r=3/4. If r>3/4, PB plays left, and If r<3/4, PB plays right.

To find Nash eq/m, for every value q b/n 0&1, we find the value of r such that (r,1-r) is
the best response by PA to (q, 1-q) by PB. The Nash eq/m is attained when PB plays (r,
1-r)= (3/4,1/4) & PA plays (q, 1-q) =(1/2, ½).

3.6 Repeated Games

Repeated games are very usual in real life:

Treasury bill auctions (some of them are organized monthly, but some are even
weekly),

Cournot competition is repeated over time by the same group of firms,

OPEC(Organization of Petrollem Exporting Countries) cartel is also repeated over

time.

It is possible to play a tit-for –tat strategy.

The tit-for-tat strategy is to start with cooperation and not confess, assuming the other
agent follows suit. For example, two competing economies can use a tit-for-tat strategy
so that both participants benefit. One economy starts with cooperation by not imposing
import tariffs on the other economy's goods and services to induce good behavior.

3.7 Sequential Game

A game where one player moves 1st & the other follows after observing the choice of the
1st . An example is the Stackelberg model, when one player is a leader & the other player
is a follower.

3.8 Prisoners Dilemma

 Two individuals have been arrested for possession of guns. The police suspects
that they have committed 10 bank robberies;

 if nobody confesses the police, they will be jailed for 2 years.

69
  if only one confesses, she’ll go free and her partner will be jailed for 40 years.

 if they both confess, they get 16 years

Matrix Representation of Prisoner Dilemma

Bontu

Confess Do not Confess

Chaltu Confess -16, -16 0, -40
Do not Confess -40,0 -2, -2

The application of Prisoners’ Dilemma in oligopoly market

 Let us look the following game that is played by firm 1 & firm 2.

Now let us assume that both firms have reached the agreement to cooperate by
charging birr 6 for a product they sell and each one will receive birr 16 Profits.

However, if one firm cheats the other by charging 4 (the other charged as before 6) it
would increase its profit while the profit of the other will fall down.

Since both have the strong incentive to cheat the other, the final outcome will be to
charge 4 & both will have a profit of 12 w/c is less than the cooperative profits, 16.

Question/s

1. In game theory, Cournot equilibrium duopoly refers to a set of optimal strategies in

which:

A. each player chooses its best strategy, no matter what the opponent does.

B. each player chooses its best strategy, given the optimal choice of its opponent.

70
D. each player chooses a strategy that entails doing to its rival whatever the rival has
done in the previous round.

E. each player tries to punish competitors that cheat on a price-fixing agreement

CHAPTER FOUR
 PRICING OF FACTORS OF PRODUCTION AND INCOME DISTRIBUTION

4.1Introduction

The mechanism of determination of factor price does not differ very much from that of
commodities. That is, factor prices are determined through the interaction of SS & DD in
the factor market. Factor inputs are generally divided into four. These are: Land, labour,
capitat and entrepreneurship.

The subject matter of the theory of income distribution is the study of the shares of
factors of production in the total output produced in the economy.

For simplicity, assume that we have 2 factors, L&K, their shares are defined as follows:

•Shares of L= (W.L)/X Shares of K=(r.K)/X where - L&K are Qty Labor & capital
employed, w & r are wage rate and rental price of capitalX=value of output in the
economy.

The factor shares depend on:

The state of technology w/c in turn defines the production function( z pr’n fu’n in
turn define factor intensities w/c is measured by K-L ratio)

The relative factor prices: The factor intensity in the production of any
commodity depends on the substitublity of factors, w/c is measured by elasticity
of substitution:

The equilibrium of the firm is defined by the tangency of isoquants and isocost lines:

MRTS L for K =w/r

4.2 Factor Pricing in A Perfectly Competitive Market

The dd for factors of production: Consider two cases

71
 When labour is the only variable factor of production

When there are several variable factors

i. Demand for a single variable factor by a firm: Assumptions

o A single commodity Q is produced in a perfectly competitive market, which

implies P is given for all firms in the market

o The goal of the firm is profit maximization

o There is a single variable factor labour, whose market is perfectly competitive.

The price of labour to the individual firm is perfectly elastic. At the going
market wage rate (W) the firm can employ or hire any amount of labour it wants.
Hence, W = MCL

Technology is given & it is represented by the production function: Q = f(L,K)

The slope of the production function is the marginal physical product of labour (MPPL).
The MPPL declines at higher levels of employment b/c of the law of diminishing MPP

PQ.MPPL = VMPL (value of marginal product of labour) = (MRPL). In other words, the
equilibrium condition for a profit maximizing firm in labour market is MCL = VMPL = W =
MRPL.

MRPL = dTR/dL =d(P*Q)/dL = PdQ/dL= PMPPL = VMPL

MCL = dTVC/dL = d(WL)/dL = WdL/dL = W

ii. Demand of a firm for several variable inputs

72
When there are more than one variable factors of production the VMPL is not its DD
curve. The reason is that the various resources (inputs) are used simultaneously in the
production of goods. In this case a change in the P of one factor leads changes in
employment of the others. A change in the employment of other factors in turn shifts
the MPP curve of the input whose P initially changed.

Consider for instance a case where a firm uses two inputs (k & L). Further assume
that the wage rate falls. Now such changes have three effects: A substitution, An
output effect and A profit maximizing effect.

The movement from A to B along the original isoquant represents the substitution
effect.

To understand this mov’t we construct an isocost line DG known as the compensated

isocost line. It has the following two characteristics

 It is parallel to the new isocost and thus represents the new input price ratio.

 It is tangent to the old isoquant Q1 & thus makes the original inputs affordable.

This implies that the firm substitutes the cheaper L for the relative expensive K.

73
 1
Therefore, the employment of L increases from L1 to L1 while that of capital decreases
from K1 to K11.

The movement from B to C on the other hand represents the output effect. After the
fall in the P of L the firm doesn’t stay at B for the firm can buy more of L & more of K.
Hence the firm can produce the higher output Q3 using both L & K , L2 and K2. The
increase of employment of L from L11 to L2 & K from K1’to K2 (corresponding the
movement from B to C) is the output effect.

The movement from C to D is the profit maximization effect. When wage rate falls, the
MC of production is reduced for every level of output. Therefore, the firm will increase
its expenditure in order to maximize its profit in a perfectly competitive market. Due to
the increase in expenditure, the isocost line EF1 must shift outwards parallel at a
distance corresponding to the increase in the firm’s total expenditure to JJ. The final
equilibrium of the firm will then be denoted by the point of tangency of the new isocost
line JJ, with the new isoquant Q4 at point D.

Thus, the increase in employment from L2 to L3 and capital from K2 to K3 (corresponding

to the movement from C to D) is the profit maximizing effect.

Determinants of Demand for Productive Resources

The price of the inputs - Negatively related; The price of output - Positively related; The
MPP of the factor –Positively related; The amount of the other factors combined with
labour Eg. Fertilizer- positively related; Technological progress (this first increases the
MPPL of an input & thus increases the demand for labour)______+vely related

The Market Demand for a Factor

The market DD for a variable input is like the market DD for a commodity. It is the sum
total of the individual firms DD. However, in the case of productive inputs the process of
addition is not a simple horizontal summation of the DD curve of the individual firms.
This is b/c when all firms expand or contract simultaneously, the market price of the
commodity changes (decrease and increases, respectively). For instance, when wage
rate falls, all firms tend to demand more labour. The increase in employment in turn
leads to an increase in total output (SS). Therefore, the market supply for the
commodity produced shifts to the right.
74
Assume given fixed market DD, W declines. This in turn will reduce the price of a
commodity. The decline in the P of the commodity further reduces the VMPL at all
levels of employment.

As a result, the VMPL curve (the individual demand curve for labour) shifts to the left.
iii. The Supply of Labour by an Individual Worker

The most important variable factors are raw materials, intermediate good, & labor.
Hence their market SS is derived in the same principle as the SS of any commodity.

The SS of L , however, requires a d/t approach. To begin with, assume that L is a

homogenous factor (all labor units are identical). This can be derived using indifference
curve analysis.

 On the horizontal axis we measure hours available for leisure and work over a
given period of time.

 On the vertical axis we measure money income.

75
What happens to the income line when wage rate increases to W2? The income line
becomes steeper.

The indifference curves (IC) represent the preferences of an individual b/n leisure/work
& income. When the wage rate is W1 an individual will earn 0A11 level of income by
working ZA hours & have 0A hours of leisure time.

If the wage rate increases to W2, the individual is in equilibrium at point B1 by working
ZB & earning is 0B11 income and devote 0B unit of time for leisure. If the wage rate
increases to W3, the individual is in equilibrium at point C1 by working ZC hrs and
earning 0C11 income & spent 0C amount of hrs for leisure. As the wage rate increases,
the amount of labor supplied increases. However, the hours devoted for work may
decline beyond some higher wage rate.
76
At wage rate W4, the individual will work ZD hrs & this is less than the amount worked
when the wage rate was W3, W2, & W1. When wage rate increase further to W5, the hrs
devoted for work decline even more. Therefore, up to W3, an increase in wage rate
creates an incentive for increased supply of labor. Above W3 LSS declines. This implies
that higher wage rates create a disincentive for longer hrs of work.

Thus, as wage rate increases, the individual’s income increases & this enables the
workers to DD more leisure than work. Hence, beyond a certain level of wage rate the SS
of labor will decrease.

The Market Supply of Labour

Although there is general agreement that the SS curve for labor by a single individuals
exhibits the back-ward bending pattern, economists disagree as to the shape of the
aggregate (market) SS of labor. Consider the case of skilled (specialized) labor

Several economists argue that in the short run the market SS of labor may have
segments of positive & negative slope. However, in the long run the SS must have a
positive slope because. Young people may plan their education in line with the expected
wages are high. Older worker may undertake retraining & change job if the wage
incentive is strong enough.

Other economists maintain that the backward bending supply curve of labor. As the
standard of living increases, people find that unless they have the time to enjoy leisure
activities it is not worthwhile to work harder in order to obtain the higher income
required for more leisure.

Thus, as income reaches the level required for a comfortable standard of living workers
put
Determinants of Market Supply of Labour

The main determinants of market SS of labour are: The price of labour (wage rate), the
tastes of consumers which defines their trade off between leisure & work, the size of
the population, The labour force participation rate (at what age people start working?),
and the occupational, educational and geographical distribution of labour force.

The r/ship b/n the SS of L & wage rate defines the L SS curve. The other determinants

77
are considered (assumed) as fixed or given. The market SS is the summation of the SS
of labour by individuals.
4.3 Factor Pricing in Imperfectly Competitive Market

The same as perfect competitive mrkt, Z intersection of DD & SS determine the price of
the factor & the level of its employment when there are imperfections in the market.

However, the determination of the DD & SS are different in the case of market
imperfection. We will consider three models with various kinds of imperfections. These
are

o MODEL A: When the firm has monopoly power in the product market & while
the factor market is perfect.

o MODEL B: When a firm has monopoly power in z product market & monopsony
power (the only buyer) in the factor (input) market.

o MODEL C: Bilateral Monopoly: When a firm has monopoly power in the product
market & the SS of labour is controlled (monopolized) by labour union.

MODEL A

a) DD of a monopolistic firm for a single variable factor

In this model we assume that the firm uses a single variable factor-labour whose
market is perfectly competitive. This means that the wage rate is given & the SS of
labour to the individual firm is perfectly elastic.

The dd curve for the product of a monopoly firm is down ward sloping, MR is smaller
than P at all level of output.

Note that, under perfect competitive market VMPL=MRPL b/c P=MR

The dd for labour by a monopolist firm is not the VMPL curve but the MRPL, which is
defined by multiplying the MPPL by MR of the commodity produced.

b) Demand for a variable labour (factor) by a monopolistic firm when several

factors are used.

When more than one variable factor are used in the production process, the dd curve is
derived from points on shifting MRPL curves. A change in the price of L (i.e W) results in
78
substitution, output, & profit maximization effects as in the care of perfectly competitive
firm.

The net result of these effects is a shift of the MRPL to the right (in general) that leads
to the equilibrium point B. Joining points such as A, B, & C at various levels of wage
rates (W) we obtain the demand curve for L (dL)

In both perfect competition & monopoly mrkt condition a firm employs a factor when
MCL = W = MRPL. But MRP equals VMP under perfect compt’n. B/c VMP = MPP.P &
MRP = MPP.MR & P = MR hence, MCL = W = MRPL (VMPL).

Under monopoly market, however, MRPL< VMPL because P>MR. Therefore, MCL = W =
MRPL < VMPL.
MODEL C: Bilateral Monopoly

In this model we assume that all firms are organized as a single body, which acts like a
monopsonist, while the L is organized in L union, which acts like a monopolist. Thus we
have a model in w/c the participants are two monopolists, one on the SS side & one on
the DD side

In general, bilateral monopoly arises when a single seller (monopolist) faces a single
buyer (monopsonist). It can be shown that the solution to a bilateral monopoly solution
is ‘indeterminate’. The model gives only the upper & lower limits with in w/c the wage
rate will be determined by bargaining.

Questions

Choose the correct answer

1. Among the following statements one is correct about demand for single variable
input in the factor market
79
 A. The value for labour exceeds marginal cost of labour for perfectly competitive
firm if the variable input is labour.
B. For perfectly competitive firm, selling price of the product is exactly the same
with that of marginal cost.
C. The slope of production function is marginal physical product of variable
input
D. The equilibrium condition for a profit maximizing perfectly competitive firm
result in value of marginal product of labour is less than marginal cost of
labour if the variable input is labour
2. Marginal revenue product of labour is
A. The slope of total revenue of labour
B. The product of marginal revenue with marginal physical product of labour
C. Exceeded by value of marginal product of labour for imperfect competitive
firm
D. A & B E. All
3. Which factors can determine demand for factors of production and its relation in
input market
A. The price of output - Negatively related C. The size of the population –
negatively related
B. The price of the inputs - Positively related D. The MPP of the factor
–Positively related

CHAPTER FIVE
GENERAL EQUILIBRIUM ANALYSIS

5.1 Introduction
80
General equilibrium model was introduced in 1874 by the great French economist, Leon
Walras. Thus, it is often called the Walrasian theory of market.

Partial Vs General Equilibrium

Partial Equilibrium

• Examines equilibrium and changes in equilibrium in one market in isolation.

• All prices other than the price of the good being studied are assumed to remain
fixed.

• All market interactions are not taken into account

• Address how equilibrium is determined in single market

General Equilibrium

• Addresses how equilibrium is determined in all markets jointly.

• All prices are variable and equilibrium requires that all markets clear

• All of the interactions between markets are taken into account

• Addresses how equilibrium is determined in all markets jointly.

5.2 General Equilibrium Theory

A GE is defined as a state where the aggregate demand does not excess the aggregate
supply for all markets. The GE approach has two central features:

1. GE views the economy as a closed and interrelated system. In GE approach

equilibrium values of all variables of interests (all markets) are simultaneously
determined

2. It aims at reducing the set of variables taken as exogenous to a small number of

physical realities

5.2.1 General Equilibrium of Exchange and Production

a. General Equilibrium of Exchange

Two individuals (A and B), & Two commodities (X and Y),

The tastes and welfare of individuals A and B are described by the following two utility

81
functions. UA = U(XA , YA) UB = U(XB , YB)

Theses functions are represented by the indifference curves

We can read from the edgeworth diagram that

82
The economy does have 10X and 8Y totally: X= 8= XA + XB Y = 10 = YA + YB

• Eg. A point such as C indicates that individual A has 3X and 6Y (viewed from origin
OA), while individual B has 7X and 2Y (viewed from origin OB ) out of the total of
1OX and 8Y.

Curve OA DEFOB is the contract curve for exchange. It is the locus of tangencies of the
indifference curves (at which the MRSxy are equal) for the two individuals where the
economy is in general equilibrium of exchange. Starting from any point not on the
contract curve, both individuals can gain from exchange by getting to a point on the
contract curve.

Along the contract curve for exchange, the marginal rate of substitution of commodity
X for commodity Y is the same for individuals A and B, and the economy is in general
equilibrium of exchange. Thus, for equilibrium, MRSA XY = MRSB XY

5.2.2 General Equilibrium of Production

We deal with a very simple economy that produces only two commodities (X and Y) with
only two inputs, labor (L) and capital (K).

Suppose that the technological relationships in the economy are as follows:

X = X(Lx , Kx)

Y = Y(Ly , Ky) Where, X and Y are the annual outputs. L and K are, respectively,
labor and capital whose subscripts indicate the corresponding output for which they are
used.

L = LX + LY

K = K X + KY where, LX , LY , KX and KY are variables with values to be solved in

the general equilibrium model. L and k are assumed to be in fixed supply.

83
 Curve 0xJMNOy is the contract curve for production. It is the locus of tangency
points of the isoquants for X and Y at which the marginal rate of technical
substitution of labor for capital is the same in the production of X and Y. That is, the
economy is in general equilibrium of production when MRTSX LK = MRTSY LK

5.3 Derivation of Production Possibility frontier (PPF)

PPF shows the alternative combinations of commodities that the economy can produce
by fully utilizing all of its resources with the best technology available to it. To determine
the conditions for simultaneous equilibrium in both exchange and production: Derive the
Production Possibility Frontier (PPF) from Edgeworth contract curve for production &
Bring the PPF and Edgeworth Box for exchange.

84
The absolute value of the slope of the PPF measures the amount of Y foregone in order
to produce one extra unit of X. It is called the marginal rate of transformation of X for Y
(MRTXY). Clearly, transformation of X for Y is made by releasing enough amount
resources from production of Y that enables production of an extra unit of X. In other
words, marginal rate of transformation is equal to the ratio of marginal cost of X to
marginal cost of Y: MRTXY = MCX /MCY.

5.4General Equilibrium of Production and Exchange

and Pareto Optimality

85
For example: at M if MRTXY = 1.5 or MCX /MCY =1.5, meaning that the economy gives up
1.5 amount of Y in order to produce an extra unit of X.

To be simultaneously in general equilibrium of production and exchange, the marginal

rate of transformation of commodity X for commodity Y in production must be equal to
the marginal rate of substitution of commodity X for commodity Y in consumption for
individuals A and B. That is, MRTXY = MRSA XY = MRSB XY =1.5

Pareto optimal or efficient by which some individuals are made better off (in their own
judgment) without making someone else worse off. Any change that improves the
wellbeing of some individuals without reducing the wellbeing of others clearly improves
the welfare of society as a whole and should be undertaken. This will move society from
a Pareto non optimal position to Pareto optimum.

Thus, a point where MRTXY = MRSA XY = MRSB XY , production and consumption are
economically efficient and society maximizes welfare.

5.5 Perfect Competition, Economic Efficiency, and Equity

At equilibriu: Perfectly competitive firms produce where MCx = Px and MCy = Py MCx /
MCy = Px/ Py = MRTxy

The third marginal condition for economic efficiency and Pareto optimum in
production and exchange: MRTxy = Px/ Py , for all consumers consuming both
commodities.

• MRTxy = MRSxy , for all consumers consuming both commodities.

5.6 Efficiency and Equity

• The first theorem of welfare economics, equilibrium in competitive markets is

Pareto optimal.

• The second theorem of welfare economics, which postulates that when

indifference curves are convex to their origin, every efficient allocation is a
competitive equilibrium for some initial allocation of goods or distribution of
inputs (income).

• At perfect competitive market,

86
 Py = MRy = MCy

On the other hand, if commodity X is produced by a firm with monopoly power,

Px > MRx and Px >MCx

Then, MRTxy = MCx/MCy= MRx/MRy< Px/Py But, Px/Py = MRSxy. If so, MRTxy < MRSxy

Therefore, the third condition for Pareto optimum and economic efficiency is violated.

If PI is the price of the input, and the input market is perfectly competitive, VMP = MRP =
PI. Otherwise, VMP = MRP > PI(Monospony market). Where VMP is value of marginal
product, MRP is marginal resource product, and PI is price of input.

Questions

Choose the correct answer

1. In general equilibrium,
A. All prices other than the price of the good being studied are assumed to
remain fixed.

B. Address how equilibrium is determined in single market

C. Addresses how equilibrium is determined in all markets jointly.

D. All
2. Which statement is true regarding to general equilibrium of exchange?
A. The functions of utility represented by using isoquant curves
B. The tastes and welfare of individuals are described through utility functions
C. Contract curve of exchange is the locus of tangencies of the isoquant curves
(at which the MRTSLK are equal) for individuals where the economy is in
general equilibrium of exchange
D. Along the isoquant curve for exchange, the economy is in general equilibrium
of exchange.

87
 CHAPTER SIX
INFORMATION ASYMETRY

6.1Introduction

In the  real world,  impossible to gain accurate information about the quality of

the goods being sold. Such  difference in access to relevant knowledge is called
information asymmetry.

88
 6.2Properties of Information

Information is not a homogeneous good.

It is hard to quantify the amount of information obtainable from various actions.

Information is a durable good.

Information is a pure public good. It is nonrival and  nonexcludable.

The  cost of acquisition of information varies significantly among  individuals.

6.3Mixed Markets for Used Cars

Example: Market for used cars

Suppose that prospective  buyers cannot distinguish between low  quality cars (lemons)
and  high quality cars (plums). If the sellers of used cars know more than the buyers. 
Because buyers cannot  distinguish between lemons and plums, there will be a single
market for the two types of used cars. Lemons and plums will be sold together in
a mixed market for the same price.

To determine price in mixed market, we must answer three questions: 

i. How much is a consumer willing to pay for a plum (a highquality car)? 

ii. How much is a consumer willing to pay for a lemon (a lowquality car)? 

iii. What is the chance that a used car purchased in the mixed market will turn out

to  be a lemon? 

89
Measuring loss due to information asymmetry

If  buyers express demand only for lemons, only lemons will be sold, Even

though both buyers and sellers of  good quality cars would be better off if high
quality goods could be identified and sold  for high price. This is market failure.

90
The gain in producer’s surplus from ‘overconsumption’ is PuBAPI. The  loss in
consumer’s surplus from overconsumption is:  APIE – (OECQU OPuBQu) =APIE – (PuEF
– FBC) = APIPuF+FBC

So, the net loss to society from ‘overconsumption’ is loss in consumer’s surplus less
gain  in producer’s surplus =APIPuF+(AFB+ABC) (ApIpuF+AFB) =ABC.

Questions

1. Suppose that due to asymmetric information, consumers in a town are not

able to exactly distinguish between original, high quality (plum), MP3
song collections and the duplicated, low quality (lemon) MP3. The
consumers do perceive the average quality. Indeed, through time the lemons
have driven out the plums out of markets. As a result, only the former exist and
the town is served with the lemon market, where the supply function is N = 20 +p;
N is number of MP3 per week. The demand in the town could have been Ninfo = 30 –
2p. However, the existing demand is uninformed one given by: Nuninfo = 40 – 3p.

i. Find the equilibrium numbers MP3 CDs sold per week and corresponding prices.

a. With uninformed demand

b. Had demand been informed
ii. Due to the information asymmetry, how much is:
a. gain in producer surplus?
b. consumer surplus loss?
c. net loss to the society?
REFERENCES
1. A. Koutsoyiannis, Modern Microeconomics
2. D.N .Dwivedi, 1997, Micro Economic Theory, 3rd Ed., Vikas Publishing
3. R.S. Pindyck & D.L. Rubinfeld, Microeconomics.
4. Hal R. Varian, Intermediate Microeconomics: A Modern Approach, 6th Ed.
5. C.L.Cole, Micro Economics: A Contemporary Approach.
6. Ferguson & Gould’s, 1989, Microeconomic Theory, 6th Ed.
7. R.R. Barthwal, Microeconomic Analysis.
8. E. Mansfield, Microeconomics: Theory and Applications.
9. D.S. Watson, Price Theory & Its Uses.

91
WOLAITA SODO UNIVERSITY

92
 Department of Economics

Development Planning and Project Analysis II

Course Code: - Econ 4132

MARCH, 2023 G.C

WOLAITA SODO, ETHIOPIA

93
Course Description

This course is the continuity of development planning and project analysis I and
focuses on development project planning and analysis. This course "Development
Planning and Project Analysis II" introduces the students how to formulate and analyze
development projects and assessing the benefits and the costs of under taking a
project and leads to the selection of the most premising project.
As you know one of the basic economic problems facing all countries in this actual
world is that of allocating limited resources to a variety of different uses in such a way
that the net benefit to society is as large as possible. A good understanding of project
planning and analysis is vital for checking the profitability of a particular investment
project made by public or private firms. Hence, it helps to allocate and use our limited
natural and human resources to the maximum economic profit benefits.
The fundamental objective of this course is to acquaint students of economics with the
methodology for project planning and analysis across different sectors and to explain
how to apply quantitative analysis of cost and benefit to evaluate projects from multiple
perspectives, i.e., from the point of view of the private sector, the public sector, and the
country as a whole.
Moreover, this course focuses on project implementation, monitoring and evaluation.
The subject matter of project analysis is outreaching beyond the Cost-Benefit analysis.
This time government and non- government organization are highly demanding experts
with a knowledge of monitoring and impact evaluations. The course is organized into
four major chapters. The first chapter is devoted to the basic concepts and cycles of a
project. The second chapter deals with financial analysis and appraisal of projects. The
third chapter builds on the economic analysis of the project. Chapters four discuss the
concepts of project monitoring and evaluation. Chapter five explains impact evaluation
with its methodologies.

Course Objective
After the end of this module students are expected
o To understand basic project preparation technique
85
o To understand and apply financial analysis of projects, the valuation of financial
costs and benefits, discounted and non-discounted project assessment criteria
o To understand the basic methodology for monitoring and impact evaluations
for different interventions

o To explain basic monitoring and impact evaluation theories and

methodologies

o To understand and apply impact evaluation techniques

86
 Chapter One: Introduction:

An Overview of Project Analysis

This chapter introduces you an overview of project analysis. Planning Projects are one
of the several instruments to achieve particular objectives in a process of development.
Thus, projects have to be discussed as an integral part of the national development
strategy for they have to be evaluated in close reference to the overall development
policy of a country. Projects have been described as "the cutting edge" of development,
they embody the policy choices flowing from development objectives and acts as the
vehicle or the medium of the described social changes.
As such then, projects are the means through which development targets are achieved
and are considered to be a tangible benefit for the project beneficiaries. Without visible
projects on the ground, policies, strategies, and plans for development are simply
administrative.
1.1 The Project Concept
1.1.1 Definition of Project

A project is a proposal for an investment to create, expand and/or develop certain

facilities in order to increase the production of goods/services/ during a certain period
of time in a community, region, country, market area and/or certain organization (firm,
public organization, NGO, etc. It is a complex set of activities where resources are used
in expectation of return and which lends itself to planning, financing and implementing
as a unit. A project can alternatively be defined as a group of tasks performed in a
definable time period in order to meet a specific set of objectives. There are different
types of projects: public, private, private individual, small, large, agricultural, industrial,
etc. An insurance company is planning to install a computer system for information
processing; the government of Ethiopia and the Sudanese government are thinking of

87
an ambitious plan to link Port Sudan with the town of Moyale; Abebe a graduate student
is planning to buy a book on econometrics. All these situations involve a capital
expenditure decision. Each of them represents a scheme for investing resources, which
can be analyzed and appraised reasonably independently.

1.1.2 Basic characteristics of a project

In all project types there are basic characteristics of capital expenditure (also referred to
as a capitalinvestment or capital project or just project). Another way of defining a
project is to outline these basic characteristics that a project exhibits, which include the
following.

1. A project involves the investment of scarce resources in the expectation of future

benefits;

2. There are measurable Objectives of a project. Projects have specific of benefits that
can be identified, quantified and valued, either socially or monetarily/commercially/.
Related to the specificity of objectives, is the fact that projects have specific
beneficiaries or clientele group, which needs to be specifically spelt out during
project planning studies.

3. A project is the smallest operational element unit. A project can be planned,

financed and implemented as a unit. Often projects are the subject of special
financial arrangements and have their own management. Despite the fact that a
project constitutes many activities and tasks, it is defined as the smallest
operational unit. The major reasons why a project is defined as the smallest
operational unit are the fact that a project is bounded by different factors. The
boundaries of projects make them distinguishable from each other.

o Projects are conceptually bounded. The problem and specific objective or needs
that justify the project involves conceptual delimitations.

o Projects are geographically bounded. Projects exist in space and we say that
projects are geographically/locationally bounded.

o Projects are organizationally bounded. Projects require the establishment of a

special organization or the crossing of traditional organizational boundaries. i.e.

88
 there should be certain organizational unit responsible for project implementation.

o Projects are time bounded. One factor that makes projects bounded is the time/life
cycle/ of a project. Projects have specific lifetime, with a specific start and end time
in which a clearly defined set of objectives are expected to be achieved. It is a
unique, one-time investment scheme.

1. Uncertainty and risks is inherent in any project. Achieving project objectives can not
be predicted in advance with accuracy. The factors that make project risk are:

o Significant and multiple types of scarce resources committed today expecting

outcome in the future;
o Benefits are expected to be generated in the future, which is less predictable;
o Capital investments are irreversible, i.e. the assumption of perfect exit
assumption of the perfect competition model is refuted.

2. It has a scope that can be categorized into definable tasks. Projects usually have
well defined sequence of investment and production activities

3. It may require the use of multiple resources. This has an implication on

management of project implementation. The more diverse the types of resources
are mobilized the more complex will the management be. The outcome of project
and hence development endeavor is sensitive to the management of each type of
resources.

1.1.3 Classification of project

The projects are basically defined in to two aspects or categories: one is defensive
project andother is aggressive project.
Defensive Project: is the project initiated to stabilize and sustain the current business
situation.
Aggressive Project: is the project initiated to enter into new business in a commercial
mannerand majorly depends upon the future prospective rather than the current
scenario.
There is other classification of projects as well which is based on the need of execution
and thetime, these can be categorized as:

89
 o Normal Project: Where the time limits are set and adequate.
o Brash Project: Where additional cost are involved to gain time.
o Disaster Project: Anything is allowed to gain time.
Projects can be further classified into various other classifications like national and
international
projects, industrial and non-industrial projects, on the basis of technology, size,
ownership,public orprivate projects, need, expansion or diversification projects.Each of
these is discussed as follows:
1. National and International Projects: This kind of projects is categorized on the basis
ofgeographical location set as countries. If one country tries to build projects with
otherforeign country, such projects are said to be international projects and when it
is done inone’s owncountry, then it is said to be a domestic or national project.
2. Industrial and Non-industrial Projects: The projects initiate in one’s own country
withan objective to make money and for commercialization, are called industrial
projects. Forexample, acar manufacturing is an industrial project. While the project
which are donefor the upliftment ofthe society and majorly done with social welfare
objectives, arecalled non-industrial projects. Forexample,building of a canal,
agricultural developmentcomes under non-industrial projects; these are mainly
carried up by the government.
3. Projects based on Technology: These are largely high technology projects
whichrequire lots of investment and works on new or non-existent technologies like
rocketlaunch project, space projects, etc. and some other are those projects which
usetechnology which are already proven like a software ERP project, automobile
automationproject, etc.
4. Projects based on its size: These projects are based on investment size or capacity
ofplant to offer goods or services. This can be further classified down to small,
medium andlarge-scale projects. Project above the investment of 100 million dollars
is considered aslarge projects.
5. Project based on ownership: This can be further classified as public sector
project,private sector project and joint sector project.
i. Public Sector Projects: Projects which are of the state, center or both forms
ofgovernments, are known as public sector projects.
90
ii. Private Sector Projects: Projects with a complete ownership of promoters
andinvestorsis known as private sector projects. Owners may be an
individual,partnership firm or acompany. These projects are mostly done with an
objectiveto earn profit and thus have a commercial nature.
iii. Joint Sector Projects: In these projects, there exist a partnership between
theentrepreneurs and the government; it may be from state government or the
centralgovernment. These types of partnership occur on the grounds of expertise
andlaisioning work and government arranges for the fund in large amounts.
Forexample, Project of Metro Train, Dams, Information technology parks,
Electricityplants and other similar natured projects.
6. Need based projects: Projects are basically driven by certain needs of the
organizationandthese needs furthers forms the basis of project categorization as
Balancing Project,Modernization Project, Expansion Project, Diversification Project,
Rehabilitation Projectand Plant Relocation Project.
i. Balancing Project: Augmenting or strengthening the capacity of particular areawithin
a chain of entire production plant with a purpose of scaling to the capacityin order to
have optimum utilization, is balancing project.
ii. Modernization Project: Upgrading the technology to increase the productivityand
inevitable approach of technology is called modernization project.
iii. Expansion Project: When the production capacity of goods and services is to
beincreased, the project that is undertaken is known as expansion project.
iv. Diversification Project: Project undertaken by the organization to completelydivert
from itscore business is called diversification project. For example, if aPetroleum
company decides toenter into Information Technology business, thenthe project will
be known as diversificationproject.
v. Rehabilitation Project: When a project is started to revive a loss bearingcompany, is
knownas rehabilitation project.
vi. Plant Relocation Project: When an organization decides to shift his plant fromone
locationto another, the project started will be known as relocation project.
1.1.4 Why Project Planning?

The quest for socio-economic development, inevitably involves the basic economic

91
problem of scarcity in the face of unlimited needs and hence the need to make choices
on the means and ends of development, which involves the rational use of limited
resources to attain the economic ends. Thus investment decisions are an essential part
of the development process. The more sound the investment decision is the more
success will be in the development endeavor. The need for project planning, preparation
and study emanates from:

i. The quest for change: dissatisfaction with the present and/or pressure or incentive
for different tomorrow;

ii. Change involves investment/commitment of resources to realize the objectives.

Investment may be defined as a long-term commitment of economic resources
made with the objective of producing and obtaining net gains in the future. The main
aspect of such commitment is the transformation of liquidity (the investor’s own and
borrowed funds) into productive assets, and the generation of liquidity again during
the use of these assets. Yet once the resources are committed, there is no way of
recovering it apart from conducting profitable operation. That is exit costs are not
zero, as it is assumed in the perfect competition model.

iii. The scarcity of investible resources and unlimited development/business needs;

iv. Investment is all about resource commitment into the future, which is less
predictable;

v. Since investment schemes involve substantial resources commitment and are

invested for the future, there is an inherent high risk involved.

vi. The costs and benefits are temporally spread and particularly the large part of the
costs are incurred earlier and the benefits are generated later on, 10-20 years for
industrial projects and 20-50 years for infrastructural projects. Then the saying goes
“ a bird at hand is better than two birds in the bush”. This raises the question of
comparing and equating the future and present values.

vii. In such a situation decision-making is not simple and perfect as it is assumed in

orthodox economics.

These features of investment decisions constitute the reasons that justify the

92
significance and relevance of project planning and the major constraints and challenges
faced by any project planner and decision maker in project viability studies. Thus,
decision makers have to make every effort to systematically rationalize their decisions
by undertaking rigorous viability studies, which involve conducting studies and
appraisal/evaluation of the same.This presupposes that the major decisions involving
substantial resources and that have wider implications on the success of an operation
are not instantaneous as the conventional assumption of rationality imply.

1.1.5 Organic Link between Policy, Development Plan and Projects

In the context of the preceding introductory remarks, the policy framework defines the
context for periodic development plans (short-, medium- and long-terms plans) which
then require specific instruments for implementation. Projects are the policy and plan
instruments, a particular decision scheme meant to convert policies and plans into
reality. So we have this generic scheme:

Policy → Development Plans → Programs→ Projects →Outcomes / impacts

/Changes

Governments and corporate entities considering their vision into the future, the external
environment and the performance of competitors set up policies which serve as a basis
for strategic /medium- and long-terms/ plans, which in turn serve as a basis for project
identification and its selection.

If there is no organic link between policies, plans and projects, then the effectiveness
and efficiency of investment decisions could be compromised. Accordingly, one has to
ensure adequate and properresponses to the following questions.

a) What is the major objective of the project? The actual aims / quotas / milestones to
be reached within a specified time, according to client requirements specified.

b) What is the basis for the demand or need for the goods/services to be produced by
the project?

c) What problem or opportunity is the project addressing?

d) How does the project contribute to the wider goals of the sector/organization/
region? I.e. whether the project is consistent with the priorities set in policy and

93
 development plan documents of a country, region, zone, woreda or a specific
organization.

e) What alternative ways of addressing the problem/opportunity/ have been

considered? What Path (_Strategy) to be followed and actions to be taken to reach
the aims and objectives.

f) Why is the proposed project the most appropriate way of addressing the
problem/opportunity;

g) What is the approximate cost and timescale Schedules of the project? _This is a
plan showing when individual / group activities will start and end and at what cost.

h) Who are the major stakeholders and beneficiaries of a project? In what ways are
they expected to participate?

i) Which institution is the most appropriate for implementation? This is about

organizing and Assigning specific people to a specific objective, as well as the
specific responsibilities for each task

j) Are there additional or special circumstances relevant to the project?

k) Standards and Determining quality for each action

The decision making process could include both the public and the private sectors. In
the public sector, there will be a political context in which policies and development
plans are set. In the corporate decision-making, there are corporate strategic plans,
which include the vision, major objectives, strategies and periodic plans. In both types
of contexts of decision-making, there is a need for projects, as the cutting edges for
converting ideas, intents, plans into deeds, achieving objectives and bringing changes.

Project planning and evaluation has a long history in financial and business analysis.
Project planning has always been used as a means of checking the profitability of a
particular investment by private firms. Recent experiences show that project analysis
has attracted the attention of development economists.But the inclusion of project
analysis in development economics did not necessarily amount to a new analytical
discovery, rather to a new approach. Projects are now assessed from the economy’s
viewpoint instead of only from the firm’s perspective. The selection criteria have also

94
included economic criteria on top of financial criteria.

Promoting projects without having development policies and plans will lead to
scattered/dispersed and unorganized development endeavours.Policies and plans
without projects means non-implementation, paper tiger decision makers, having policy
and plan documents for other purposes.Governments usually have plans and
development plans for publicity and propaganda sake or to respond to external or
internal pressures. Projects are the cutting edges of development plans. Development
endeavour without projects is unperceivable.

In this line developing countries are negotiating, requesting, struggling with bilateral and
multilateral donors and lenders for budget support instead of project financing. This is
because project financing has been less effective to transform economies and bring
about expected results. Multilateral institutions, though are accepting and appreciating
the significance of budget support and limitations of project financing, they argue
against budget support on the pretext that governments abuse donor’s money.
Governments can use donor’s money for their specific political ends and abuse or they
have weak implementation capacity and hence supervisory and monitory capacity.

1.1.6 The linkage between projects and programs

Most developing countries in general have some sort of national planning of course the
degree and complexity of such development plans vary from country to country and
even in a particular country from time to time. For instance, in Ethiopia, Planning was
much centralized in the 1974-91 periods compared to either before or after this period.
Project formulation is an integral part of a more broadly focused and continuous
process of development planning.

Projects can also be understood as an activity for which more will be spent in
expectation of returns and which logically seems to lend itself to planning, financing,
and implementing as a unit. It is the smallest operational element prepared and
implemented as a separate entity in a national plan or program. In general, thus, sound
development plans require good and realistic projects for the latter are the concrete
manifestation of the pan as noted above.

Projects in such context are the concrete manifestations of the development plans and
95
programs in a specific place and time. One can think of projects as subunits and bricks
of programs, which constitute a component of or the entire national plan.

It is necessary to distinguish between projects and programs because there is

sometimes a tendency to use them interchangeably. While a project refers to an
investment activity where resources are used to create capital assets, which produce
benefits over time and has a beginning and an end with specific objectives, a program is
an ongoing development effort or plan involving a number of projects. Programs may or
may not necessarily be time bounded. Yet programs cannot live forever, they have
limited life cycle, which however, may or may not be explicitly stated. So in effect in
terms of time delimitation, there is only relative difference between programs and
projects.

A development plan is a statement of action meant to realize and implement economic

policy. National development plans are further disaggregated into a set of sectoral
plans which involve a number of programs and projects. A development plan or a
program is therefore a wider concept than a project. It may include one or several
projects at various times whose specific objectives are linked to the achievement of
higher level of common objectives.

Note that projects can stand alone without being part of certain program. So one can
visualize the possibility of policies → development plans → projects. Projects, which
are not linked with others to form a program, are sometimes referred to as “stand alone”
projects.

Program study that incorporates a multiple of projects requires three steps:

 The analyst must appraise each project independently.

 The analyst must appraise each possible combination of projects.

 The analyst must appraise the entire program, including all the projects, as a
package.

Examples could be a road development program, a health improvement program, a

nutritional improvement program, a rural electrification program, institutional reform
program, management system reform program, etc.

96
A health program may include a water project as well as a construction of health
centers both aimed at improving the health of a given community, which previously
lacked easy access to these essential facilities.

1.1.7 Uniqueness of Projects

In general every project is unique in the sense that there are factors that distinguish
projects from others. Some of the main factors which bring about differences in the
nature of projects and that determine the breadth and depth of project studies include:

 size/scale/, small-, medium- and large- scales of projects;

 markets; projects catering to regional, national or international markets,

 Technologies, heavy, light, mature or newly evolving technology, factor intensity,

etc.

 Economic and locational context: Rural and urban projects, projects in LDCs and
DCs, etc.

 financial and other resources availability,

 the macro economic situation at which the particular project is being considered,

 the level of competition, high or low competition, local or global competition,

 The type of sector/industry of a project eg. Good (soap, computer) or service

(education, health, banking, insurance), public good or private good, industrial or
agricultural project, etc.

 Ownership (private and public projects) which has wider implication on the
breadth and depth of coverage.

 Impact/outcome: Projects could be different because of their major impacts.

There are differences in projects in terms of their social and environmental
impacts, which may be (and are gaining importance since the recent past
decades) important variables that determine the level and type of studies
required.

It has to be noted that the exercise of identifying the factors that distinguish a project
from another one is not by itself an end in the practical world. Rather the concern is in
97
identifying the variables that have significant implication on the viability of a project and
the need for explicit consideration of the same in the same study.

So apart from discussing the principles and major procedures that need to be adhered
to, one cannot reflect the specific behaviors of different projects, be agricultural,
manufacturing, service-rendering projects in such level of treatment.

It is therefore the task of the project analyst to decide which characteristic of the
project must be underlined.

1.2 The project Cycle

A project cycle is a sequence of events, which a project follows. These events, stages or
phases can be divided into several equally valid ways, depending on the executing
agency or parties involved. Some of these stages may overlap. Capital expenditure
decision is a complex decision process, which may be divided into the following broad
phases.

1. Identification/Opportunity study/

2. Project preparation, which include:

 Pre-feasibility Study

 Feasibility (technical, financial, economic)`

 Support study

 Appraisal/evaluation/

3. Implementation/investment

4. Ex-post evaluation

Alternative categorization is (UNIDO, 1991 pp 10-22):

1. Pre-investment phase;

a. Identification/opportunity study/

b. Pre-feasibility study/ pre-selection/

c. Feasibility study

d. Support study;
98
 e. Appraisal study.

2. Investment phase;

 Negotiating and contracting;

 Engineering design;

 Construction;

 Procurement

 Erection and installation

 Pre production marketing;

 Manning and training

3. Operation phase.

a. Commissioning and hand over and starting of operation

b. Post project evaluation/appraisal/

c. Replacement/rehabilitation

d. Expansion/innovation

Throughout the project cycle, the primary preoccupation of the analyst is to consider
alternatives, evaluate them, and to make decision as to which of them should be
advanced to the next stage. If it is decided to proceed to the next stage, the results (out
puts) of a given stage serve as the input or part of the input of the next sage.

1.2.1 Identification (Opportunity studies)

The first stage in the project cycle is to find potential projects. It is the identification of
investment opportunities.Project ideas can emanate from a variety of sources. Much
depends on the experience, and even the imagination, of those entrusted with the task
of initiating project ideas. In general, one can distinguish two levels where project ideas
are born: The macro level and the micro level. At the macro level, project ideas emerge
from:

1. National policies, strategies and priorities as may be initiated from time to time;

2. National, sectoral, sub-sectoral or regional plans and strategies supplemented by

99
 special studies, sometimes called opportunity studies, conducted with the aim of
translating national and sectoral sub-sectoral and regional programs into specific
projects;

3. General surveys, resource potential surveys, regional studies, master plans,

statistical publications which indicate directly or indirectly investment opportunities;

4. Constraints on the development process due to shortage of essential infrastructure

facilities, problems in the balance of payments, etc.;

5. Government decisions to correct social and regional inequalities or to satisfy basic

needs of the people through the developments of projects;

6. A possible external thereatthat necessitates projects aiming at achieving, for

example,self sufficiency in basic materials, energy, transportation, etc;

7. Unusual events such as draughts, floods, earth-quake, hostilities, etc.;

8. Government decision to create project-implementing capacity in such areas as

construction, etc.

9. At the macro-level, Project ideas can also originate from multilateral or bilateral
development agencies and as a result of regional or international agreements on
which the country participates.

In addition, individual/entrepreneurial/ inspiration, institutions, workshops, trade fairs,

development experiences of other countries may point to some interesting project
ideas.

At the micro-level, the variety of sources is equally broad. Project ideas may emanate
from:

1. The identification of unsatisfied demand or needs

2. The existence of unused or underutilized natural or human resources and the

perception of opportunities for their efficient use

3. The need to remove shortages in essential material services, or facilities that

constrain development efforts

4. The initiative of private or public enterprises in response to incentives provided by

100
 the government.

5. The necessity to complement or expand investments previously undertaken, and

6. The desire of local groups or organizations to enhance their economic status and
improve their welfare

Project proposals could also originate from foreign firms either in response to
government investment incentives or because they consider production within the
country a better way to secure a substantial share of the domestic market for their
products.

1.2.2 Project preparation: Analysis and Appraisal phase

Once project ideas have been identified and selected for further examination, the
process of project preparation and analysis starts. Project preparation must cover the
full range of technical, institutional, economic, and financial conditions necessary to
achieve the project’s objective. Critical element of project preparation is identifying and
comparing technical and institutional alternatives for achieving the project’s objectives.
Different alternatives may be available and therefore, resource endowment (labor or
capital) would have to be considered in the preparation of projects. Preparation thus
require feasibility studies that identify and prepare preliminary designs of technical and
institutional alternatives, compare their costs and benefits, and investigate in more
details the more promising alternatives until the most satisfactory solution is finally
worked out. It involves generally three steps:

 Pre-feasibility studies
 Feasibility studies
 Support studies;
 Appraisal of studies
1.2.2.1 Pre-feasibility Study (Pre-selection/ Preliminary Screening)
The identification process will give the background information for defining the basic
concept project, which leads to the feasibility study stage. Once a project proposal is
identified, it needs to be examined. Once some project ideas have been put forward, the
first step is to select one or more of them as potentially promising. To begin with, a
preliminary project analysis is done. A prelude to the full blown feasibility study, this

101
exercise is meant to assess:
1. whether the project is prima facie worthwhile to justify a feasibility study and
2. what aspects of the project are critical to its variability and hence warrant an in
–depth investigation.
At this stage, the screening criteria are rough and vague, becoming specific and refined
as project planning advances. During preliminary selection, the analyst should eliminate
project proposals that are technically unsound and risky, have no market for their output,
have inadequate supply of inputs, are very costly in relation to benefits, assume over
ambitious sales and profitability, etc.
Some kind of preliminary screening is required to eliminate ideas, which prima facie, are
not promising. For this purpose the following aspects may be looked into:
Compatibility with the promoter
 Consistency with government priorities
 Availability of inputs
 Adequacy of market
 Reasonableness of cost, and
 Acceptability of risk level
When a firm evaluates a large number of project ideas, it may be helpful to stream line
the process of preliminary screening. For this purpose, a preliminary evaluation may be
translated into project rating index. The steps involved in determining the project-rating
index are as follows:
1. Identify factors relevant for project rating
2. Assign weights to these factors (the weights are supposed to reflect their
relative importance)
3. Rate the project proposal on various factors, selecting a suitable rating scale
4. For each factor multiply the factor rating with the factors weight to get the factor
score
5. Add all the factor scores to get the overall project-rating index.
Once the project-rating index is determined, it is compared with a pre-determined hurdle
value to judge whether the project is prima facie worthwhile or not.
As a result of the preliminary screening exercise, a project profile, an opportunity study
report, or an identification study report, as appropriate, is prepared showing which
102
project alternatives should be rejected and which ones may be advanced to the next
stage.
1.2.2.2 Feasibility Study

The major difference between the pre-feasibility and feasibility studies is the amount of
work required in order to determine whether a project is likely to be viable or not. If the
preliminary screening suggests that the project is prima facie worthwhile, a detailed
analysis of the marketing, technical, financial, economic, and ecological aspects is
undertaken. Feasibility study provides a comprehensive review of all aspects of the
project and lays the foundation for implementing the project and evaluating it when
completed. The focus of this phase of capital budgeting is on gathering, preparing, and
summarizing relevant information about various project aspects, which are being
considered for inclusion in the capital investment. Based on the information developed
in this analysis, the stream of costs and benefits associated with the project can be
defined. At this stage a team of specialists (Scientists, engineers, economists,
sociologists) will need to work together. At this stage more accurate data need to be
obtained and if the project is viable it should proceed to the project design stage.
Appraisal should cover major aspects like technical, institutional, economic and
financial.
The final product of this stage is a feasibility report. The feasibility report should contain
the following elements:
2. Background of the project

3. Market analysis /identifypotential buyers, associated marketing costs

4. Technical analysis(materials & Inputs, Technology and engineering works,
construction, infrastructure)
5. Organizational analysis:- Will the solution work in the organization if
implemented
6. Financial analysis:-how much start-up capital is needed, sources of capital,
returns on investment, etc.
7. Economic analysis :- cost/benefit analysis
8. Social analysis, and
9. Environmental analysis
103
Support Studies
Support or functional studies cover specific aspects of an investment project, and are
required as pre requisites for, or in support of, pre-feasibility and feasibility studies of
particularly large-scale investment proposals, the viability of which critically depends
upon the quantity and quality of certain input or aspect of that project.

This type of study is justified when a detailed study required for a specific aspect/input/
is too involved to be undertaken as part of the feasibility study. Alternatively, the
decision towards undertaking a feasibility study could be dependent upon the outcome
of a support study.

Example: Cement processing is tied to the source of major raw materials, which are
lime stone and sandstone. Since the requirement is bulky, one cannot think of a cement
factory located at a distance from the source of these raw materials. So there is little
room for outsourcing from distant locations or imports. Since cement production is
critically dependent upon the availability of adequate quantity and the right quality of
these raw materials, a support study is justified before commissioning a full-fledged
feasibility study.

Appraisal of an investment Decision(ex ante evaluation)

Thus project appraisal can be defined as a second look at the project report by a team
of professionals, who were not participated in the preparation of the study but qualified
and experienced to evaluate such studies. It is or should be an independent assessment
of the project to identify the weaknesses and strengths of the study that have a bearing
on the decision to invest, and/or to finance the project. Appraisal is the comprehensive
and systematic assessment of all aspects of a project study, addressing particularly
issues like:

 Specificity of objectives;

 Clarity of problems;

 Methodology: type and source and appropriateness of data collection techniques

and analysis techniques;

 Project specific factors.

When a feasibility study is completed the various parties involved in the project will

104
carry out their own appraisal of the investment project in accordance with their
individual objectives and evaluation of expected risks, costs and gains.

The prime objective of project appraisal should be to identify the weaknesses that have
bearing on decision-making and identify means of strengthening it adequately to ensure
final success of the project. The main objective is then to improve and revamp the
project.

The appraisal report concentrates on the health of the company to be financed, the
returns obtained by equity holders and the protection of its creditors. The techniques
applied to appraise the project in line with these criteria center around technical,
commercial, market, managerial, organizational, and financial and possibly also
economic aspects. The findings of this type of appraisal enter into the appraisal report.

Appraisals as a rule deal not only with the project but also with the industries in which it
will be carried out and its implications for the economy as a whole. For large-scale
projects, appraisal report will require field missions to verify the data collected and to
review all those factors of a project that are conditioned by its business environment,
location and markets and the availability of resources.

Implementation/Investment phase/
After the project design is prepared negotiations with the funding organization starts
and once source of finance is secured implementation follows. Implementation is the
most important part of the project cycle. The better and more realistic the project plan
is the more likely it is that the plan can be carried out and the expected benefits realized.

Project implementation must be flexible since circumstances change frequently.

Technical changes are almost inevitable as the project progresses; price changes may
necessitate adjustments to input and output prices; political environment may change.

Translating an investment proposal into a concrete operational unit is a complex, time

consuming and risk fraught task. Delays in implementation, which are common, can
lead to substantial cost overrun. For expeditious implementation at a reasonable cost,
the following are helpful.

1. Adequate formulation of projects. A major reason for the delay is inadequate

formulation of projects. Put differently if necessary homework in terms of preliminary
105
studies and comprehensive and detailed formulation of projects is not done, many
surprises and shocks are likely to spring on the way. Hence the need for adequate
formulation of the project cannot be overemphasized.

2. Use of the principle of responsibility accounting. Assigning specific responsibilities

to project managers for completing the project within the defined time frame and cost
limits is helpful in expeditious execution and cost control.
3. Develop project management competence: Use of network techniques. For project
planning and control two basic techniques are available - PERT (program evaluation
Review Technique) and CPM (Critical Path Method). These techniques have lately
merged and are being referred to by common terminology that is network techniques.
With the help of these techniques, monitoring becomes easier.
The investment phase can be divided into the following stages:
1. Establish project management office which involve establishing of the legal, financial
and organizational basis for the implementation of the project
2. Technology acquisition and transfer, including basic and detailed engineering, which
include
 tender preparation (hence developing the terms of reference), tendering, tender
analysis, selection of a supplier,
 negotiation and contracting;
 Procurement of major technology for installation and other inputs necessary for
construction and installation of the system;
3. Engineering design;
4. Construction work
5. Installation and erection;
6. Pre-production marketing, including the securing of supplies and setting up the
administration of the firm
7. Recruitment and training of personnel, and

8. Plant commissioning and start-up (Alternatively, this function may be categorized in

the operation phase).

This implementation basically involves capability in project management. The function

of project management is to foresee or predict as many of the dangers and problems
106
as possible and to plan, organize and control activities so that the project is completed
successfully in spite of the risks. Project management is the planning, organizing,
directing, and controlling of resources for a specific time period to meet a specific set
of one-time-objectives. This process starts before any resources are committed and
must continue until all work is finished. The aim is for the final result to satisfy the
project sponsor or purchaser, within the promised timescale and without using more
money and other resources than those, which were originally set aside or budgeted for.
Since there are different types of projects, the management of these different types of
projects is also different reflecting the peculiarity of the projects.

The Common contraints in implementation

1. Over optimistic estimate at inception (economic policy and social environment)

2. Inappropriate technology choice.

3. Shortage of qualified and experienced personnel.

4. Lack of prompt decisions on certain issues, like selection of sites for carrying out
project activities.

5. High cost of input (feed shortage for livestock projects)

6. Inefficiency of the contracting firms resulting in delays on finalization of

construction/machinery delivery.

7. Change of project personnel (trained personnel leave jobs before implementation is

completed).

8. Natural calamities caused by floods, road blots due to landslides, and disruption of
the operation of important service facilities.

9. Lack of proper communication facilites between the field units, project

headquarters and the creditor/s.

10. Unhealthy atmosphere created by political upheaval in the project area, (labor strike,
change in government etc.).

11. Corruption.

The operational phase

107
Project operation involves the running and maintenance of new entity in accordance
with set objectives and planned tasks.

The problems of the operational phase need to be considered from both a short-and
long-term viewpoint. The short-term view relates to the initial period after
commencement of production when a number of problems may arise concerning such
matters as the application of production techniques, operation of equipment or
inadequate labour productivity owing to a lack of qualified staff. Most of these
problems have their origin in the implementation phase. The long-term view relates to
chosen strategies and the associated production and marketing costs as well as sales
revenues. These have a direct relationship with the projections made at the pre-
investment phase. If such strategies and projections are proved faulty, and remedial
measures will not only be difficult but may prove to be highly expensive.
The operational phase involves the following main functions.
1. Commissioning and starting of commercial production;
2. Post-project evaluation
3. Replacement/rehabilitation
4. Expansion /innovation.

Aspects of Project Preparation and Analysis

1. Marketing and Demand (Commercial) Aspect
 concerns with arrangement of markets for project inputs and outputs
 Inputs: quality, quantity and price on the right time
 Outputs: where to sell project products
 Factors to be considered (different sides of the market)
 Consumption trends of the past and future
 Production possibilities and constraints
 Import and export analysis
 Nature of competition
 Elasticity of demand and supply
 Consumer’s behavior, preferences, attitudes
 This calls for Situational analysis! Asking Qs like …

108
 o Who are the consumers of the product?
o What kind of substitutes?
o What kind of marketing arrangements and institutions will be involved?
 This may require use of
o Primary Market survey information
o Secondary information

2. Technical aspect
Involves technicians like engineers, soil scientists', agronomists, economists, livestock
experts, etc. In technical analysis every person involved in the project should know how
to examine
 Material inputs & utilities (raw materials like organic materials, mineral deposits,
forest products, marine products; processed materials and utilities like energy,
water, telephone, etc.)
 Auxiliary materials (oils, paints, grease, etc.)
 Manufacturing (production) processes (type of technology: capital or labor
intensive)
 Plant capacity (medium, large or small)
 Location and site
 Machinery and equipment
 Structure and other civil works

3. Institutional aspects

Institutions are the laws, rules, regulations, customs, justice systems, religions, and
social pressures that encourage or constraint people in the quest to maximize their
welfare. It may affect
 Working behavior of the society
 Land tenure
 Local committees like water, capital, etc
 Local money rotational systems

4. Organizational aspect

Relationship b/n project administrative organization and the existing agencies

109
  Is separate project authority needed?
 The authority & responsibility of the executive staff &agencies should be clearly
defined and linked
5. Managerial and administrative aspect: Is the project run by a separate staff or
the beneficiaries also run the project?
6. Social aspects: Refers to the project's contribution to the society:
employment generation
Income distribution
Minimization/mitigation of side effects (displacements, waste products,
etc )
Concerning quality of life

7. Financial aspects: analyze the financial impact of the projects on participants and
measure efficiency, incentives, credit worthiness and liquidity so created

8. Economic aspects: refers to determination of likelihood that the proposed project

would contribute to the overall economic dev’t of the society & justify to add
sufficient returns for the resources used

9. Ecological analysis:environmental impact of the project

In general,
 A project should include all or part of these aspects depending on its size and
impact.
 Of these aspects financial and economic analysis are the concerns of
economists

Chapter Two: Financial Analysis and Appraisal of Projects

2.1. Scope and Rationale
2.1.1. When to undertake financial Analysis
A financial analysis must be undertaken if it is necessary to determine the financial

110
profitability of project to the project implementer. It will be worthwhile to carry out a
financial analysis if the output of the project can be sold in the market or can be valued
using market prices. This applies to private and public investments. A private firm will
primarily be interested in undertaking a financial analysis of any project it is considering
and seldom will it under take an economic analysis. But commercial government
authorities that are selling out put such as telecommunications, electric power, etc will
usually under take a financial and an economic analysis of any project it is undertaking.
Even non-commercially oriented government institutions may sometimes wish to
choose between alternative facilities on the basis of essentially financial objectives. For
example, in the case of a hospital service the management of the hospital may be
required to provide the cheapest services. Under such circumstances a cost
minimization or cost effectiveness exercise will be undertaken.
2.2. Identification of Costs and Benefits
In project analysis, the identification of costs and benefits is the first step. The costs
and benefits of a project depend on the objectives the project wants to achieve. So, the
objectives of the analysis provide the standard against which cost and benefits are
defined. A cost is anything that reduces an objective, and a benefit is anything that
contributes to an objective. However, each participant in a project has many and
different objectives.
Whatever the nature of the project, its implementation will always reduce the supply of
inputs (" consumed" by the project). With out the project, the supply of these inputs and
outputs to the rest of the economy would have been different. (Examining this
difference between the availability of inputs and out puts with and with out the project is
the basic method of identifying its costs and benefits.) In many cases the Situation
without the project is not simply a continuation of the status quo, but rather the
Situation that is expected to exist if the project is not under taken, because some
increases in output and costs are often expected to occur any way. Different
participants in a project have many and different objectives.

For example:
1. For a farmer, a major objective of participating may be to maximize family

111
income. But this is only one of his objectives. He may also wish his children to be
educated, which reduces the available labor force for farm work. Taste preferences may
force the farmer to continue growing a traditional variety although a new and high
yielding variety may be available. He may also wish to avoid risk and thus continue
cropping a variety, which he knows well.
2. For a private business firm or government corporations a major objectives is to
maximize net income, yet both have significant objectives other than simply making the
highest possible profit. Both will want to diversify their activities to reduce risk. A public
corporation bus may for instance decide to maintain Services even in less densely
populated areas or at off peak hours and there by reduce its net income.
3. A Society as a whole will have as a major objective increased national income,
but it clearly will have many significant, additional objectives. One of the most important
of these is income distribution. Another may be to increase the number of productive
job opportunities so that unemployment may be reduced- which may be different from
the objective of income distribution. Another may be to increase the number of
productive job opportunities so that unemployment may be reduced - which may be
different from the objective of income distribution it self. An other objective may be to
increase the proportion of saving for future investment, or there may be other broader
objectives such as increasing regional integration, raising the level of education,
improve rural health, or safeguard national security. Any of these may lead to the choice
of a project that is not the alternative that would contribute most to national income
narrowly defined.
No formal analytical technique could possibly take in to account all the various
objectives of every participant in a project. Some selection will have to be made. Most
often the maximization of income is taken as the dominant objective of the firm
because the single most important objective of an individual economic agent is to
increase income and increased national income is the most important objective of
national economic policy. Anything that reduces national income is a cost and anything
that increases national income is a benefit. Thus anything that directly reduces the total
final goods and services is obviously a cost, and anything that directly increases them is
a benefit. The task of the economic analyst will be to estimate the amount of the
increase in national income available to the society i.e. to determine whether, and by
112
how much, the benefits exceed the costs in terms of national income.
Quantification
Once costs and benefits are enumerated the next step is accurate prediction of the
future benefits and costs which then be quantified in Dollars and cents. Thus,
quantification involves the quantitative assessment of both physical quantities and
prices over the life span of the project.
The financial analysis of projects is typically based on accurate prediction of market
prices, on top of quantity prediction. It is worth thinking about the impact of the project
it self on the level of prices; and the independent movement of prices due other factors.
The same principle applies in the Sense of economic analysis the only difference being
the price needs to be changed to reflect net efficiency benefits to the nations at large.
One widely accepted" efficiency" measure is its actual or potential value as an import or
export; similarly the opportunity cost of any input is related to the question of its
potential contribution to foreign exchange. In other words, world prices are considered
as efficiency price indicators compared to domestic prices. However, to take account of
the distribution impact of project further adjustment of such price is required. This
lends itself too the social cost-benefit analysis.
2.3. Classification of Costs and Benefits
2.3.1. Tangible costs and benefits of a project
The first question that the project analyst needs to know is whether it is one project that
is to be evaluated or several alternatives? Determining the relevant alternative project
based perhaps on technology, size, or length of time required for the phasing out of the
project etc, is critical problem.
2.3.1.1. Tangible costs of a project
In almost all project analyses costs are easier to identify and value than benefits. In
examining costs the basic question is whether the item reduces the net benefit or the
net income of a firm (project owner). The prices that the project actually pays for inputs
are the appropriate prices to use to estimate the project's financial costs. These prices
may include taxes, tariffs, monopoly or monophony rents, or be net of subsidies. Some
of the project costs are tangible and quantifiable while many more are intangible and
non quantifiable. The costs of a project depend on the exact project formulation,

113
locations, resource availability, or objective of the project.
Conceptually; the cost of project represents the total of all items of out lay associated
with a project, which are supported by long-term funds. It is the sum of the outlays on
the following items:
 The cost of land and site development
 Land charges
 Payment for lease
 Cost of leveling and development
 Cost of laying approach roads and internal roads
 Cost of gates
 Cost of tubes wells
 The cost of buildings and civil works
 Buildings for the main plant and equipments
 Buildings for auxiliary services (steam supply, work shops, laboratory, water
supply etc.)
 Ware houses and shower rooms
 Non-factory buildings like guesthouse, canteens.
 Silos, tanks, wells, basins, etc
 Garages and work shops
 Other civil engineering works
 The cost of plant and Machinery
The cost of plant and machinery, typically the most significant component of
project cost, consists of the following.
 Cost of imported machinery: This is the sum of (i) FOB (Free on board) value, (ii)
shipping, freight, and insurance cost, (iii) import duty, and
(iv) Clearing, loading, unloading, and transportation charges.
 Cost of local machinery:
 Cost of stores and spares
 Foundation and installation charges
The cost of plant and machinery is based on the latest available quotation adjusted for
possible escalation. Generally, the provision for escalation is equal to the following
product: (latest rate of annual inflation applicable to the plant and machinery) x (length
114
of the delivery period)
 Technical know-how and Engineering fees.
Often it is necessary to engage technical consultants or collaborators from local or
abroad for advice and help in various technical matters like preparation of project report,
choice of technology, selection of plant and machinery, detailed engineering, and so on.
While the amount payable for obtaining technical know-how and engineering services
for setting up the project is a component of project cost, the royalty payable annually,
which is typically a percentage of sales, is an operating expense taken in to account in
the preparation of the projected profitability statements.
 Expenses on Foreign Technicians and Training of local technicians abroad.
Services of foreign technicians may be required for Setting up the project and
supervising the trial runs. Expenses on their travel, boarding, and loading along with
their Salaries and allowances must be shown here. Likewise, expenses on local
technicians who require training abroad must also be included here.
 Miscellaneous Fixed Assets
 Fixed assets and machinery, which are not part of the direct manufacturing
process, may be referred to as miscellaneous fixed assets. They include items like
furniture, office machinery and equipment, tools, vehicles, railway siding, laboratory
equipments, workshop equipmentsetc, and deposits made with the electricity board
may also be included here.
 Preliminary and capital issue expenses
 Expenses incurred for identifying the project, conducting the market Survey,
preparing the feasibility report, drafting the memorandum and articles of association
are referred to as preliminary expenses.
 Expenses borne in connection with the raising of capital from the public are
referred to as capital issue expenses. The major components of capital issue expenses
are: Under writing commission, brokerage, fees to managers and registrars, printing and
postage expenses, advertising and publicity expenses and stamp duty.
 Pre-operative Expenses
Expenses of the following types incurred till the commencement of commercial
production are referred to as pre-operative expenses:
 Establishment expenses
115
 Rents, taxes and rates
 Traveling expenses
 Interest and commitment charges on borrowings
 Insurance charges
 Mortgage expenses
 Interest on deferred payments
 Start up expenses
 Miscellaneous expenses.
 Provision for contingencies
A provision for contingencies is made to provide for certain unforeseen expenses and
price increases over and above the normal inflation rate, which is already incorporated
in cost estimates.
To estimate the provision for contingencies; (i) Divide the project cost items into two
categories, i.e. firm cost items and non-firm cost items (firm cost items are those which
have already been acquired or for which definite arrangements have been made.) (ii) Set
the provision for contingencies at 5 to 10 percent of the estimated cost of non-firm cost
items. Alternatively, make a provision of 10 percent for all items (including the margin
money for working capital) if the implementation period is one year or less. For every
additional one-year, make an additional provision of 5 percent.
Commercial banks and trade creditors provide the principal support for working capital.
However, a certain part of working capital requirement has to come from long-term
sources of finance. Referred to as the "margin money for working capital" this is an
important element of the project cost.
To meet the cost of project the following means of finance are available: Share capital,
Term loans, Debenture capital, Deferred credit, Incentive Sources, andMiscellaneous
Sources
Share capital: There are two types of Share capital- equity capital and preference capital.
Equity capital represents the contribution made by the owners of the business, the
equity shareholders, who enjoy the rewards and bear the risks of owner ship. Equity
capital being risk capital carries no fixed rate of dividend. Preference capital represents
the contribution made by preference shareholders and the dividend paid on it is
generally fixed.
116
Term loans: Provided by financial institutions and commercial banks, term loans
represent secured borrowings, which are a very important source for financing new
projects as well as expansion, modernization, and renovation schemes of existing firms.
Debenture capital: Debentures are instruments for raising debt capital. There are two
broad types of debentures: non-convertible debentures and convertible debentures. Non
-convertible debentures are straight debt instruments. Typically they carry a fixed rate of
interest and have a maturity period of 5 to 9 years. Convertible debentures, as the name
implies, are debentures, which are convertible, wholly or partly, in to equity shares. The
conversion period and price are announced in advance.
Deferred credit: Many a time the suppliers of plant and machinery offer a deferred
credit facility under which payment for the purchase of plant and machinery can be
made over a period of time.
Incentive sources: The government and its agencies may provide financial support as
incentive to certain types of promoters or for setting up investment in certain location.
Miscellaneous sources: A small portion of project finance may come from
miscellaneous sources like unsecured loans, public deposits, and leasing and hire
purchase finance.
2.3.1.2. Tangible Benefits
Tangible benefits can arise either from increased production or form reduced costs.
The specific forms, in which tangible benefits appear, however, are not always obvious
and valuing them might be difficult. In general the following benefits can be expected.
 Increased production
 Quality improvement
 Changes in time of sale changes in location of sale
 Changes in product form
 Cost reduction through technological advancement
 Reduced transport costs
 Other kinds of tangible benefits.
2.3.2. Intangible costs and Benefits
There may be some costs and benefits that are intangible. These may include the
creation of new employment opportunities, better health and reduced infant mortality as

117
a result of more rural clinics, better nutrition, reduced incidence of waterborne diseases,
national integration, or even national defense. Such intangible benefits. However, do not
readily lend them selves to valuation. Under such circumstances one may have to resort
to the least cost approach instead of the normal benefit cost analysis.
Although the benefits may be intangible most of the costs are tangible. Construction
costs for schools, hospitals, pipes for rural water supply, etc are all quantifiable.
However, cost such as the disruption of family life, the increased pollution as a result of
the project, ecological imbalances as the result of the project, etc, are difficult to
capture and quantify. But effort should be made to identify and quantify wherever
possible.
2.4. The valuation of financial costs and benefits
How to value project costs and benefits in financial analysis
The financial benefits of a project are just the revenues received and the financial costs
are the expenditures that are actually incurred by the implementing agency as a result
of the project. If the project is producing some goods and services for sale the revenue
that the project implementer expects to receive every year from these sales will be the
benefits of the project. The costs incurred are the expenditures made to establish and
operate the project. These include capital costs, the cost of purchasing land, equipment,
factory buildings vehicles, and office machines, working capital as well as its ongoing
operating costs; for labor, raw material, fuel, and utilities.
In financial analysis all these receipts and expenditures are valued as they appear in the
financial balance sheet of the project, and are therefore, measured in market prices.
Market prices are just the prices in the local economy, and include all applicable taxes,
tariffs, trade mark-ups and commissions. Since the project implementers will have to
pay market prices for the inputs and will receive market prices for the out puts they
produce, the financial costs and benefits of the project are measured in these market
prices. In a freely perfectly competitive market, without taxes or subsidies the market
price of an input will equal its competitive supply price at each level of production. This
is the price at which producers are just willing to supply that good or service. The supply
curve will reflect the opportunity cost, or the value in their next best alternative use of
the resources used to produce that input. In equilibrium the supply price of an input will

118
equal to its demand price at the market-clearing price for that input.
The financial benefit from a project is measured in terms of the market value of the
project's output, net of any sales taxes. If the project's out put is sold in a competitive
market with no rationing or price control for the good concerned, and the project is
small and does not change the good's price, its market price will equal its competitive
demand price. This is a minimum measure of what people are willing to pay for a unit of
the good or service (produced by the project, at each level of out put demanded).
Secondary costs and benefits.
We may distinguish between primary and secondary costs. The former is concerned
with the direct project outputs and inputs. The latter, however, exist where the project
enables more efficient use of resources to be made elsewhere or leads to external
claims on resources elsewhere. Project might lead to benefits created or costs incurred
outside the project it self. So project analyst must also consider the external or
secondary costs so that they can be properly attributed to project costs investment.
This is more a problem of economic analysis and not a concern of financial analysis.
The tracing through of Secondary effects is the proper subject of economic analysis.
The Treatment of Transfer payments in Financial Analysis
Some payments that appear in the cost streams of the financial analysis do not
represent direct claims on the nation's resources but merely reflect a transfer of the
control over resource allocation from one member or sector of society to an other. For
example, the payment of interest by the project entity on a domestic loan merely
transfers purchasing power from the project entity to the lender. Direct transfer
payments include taxes, subsidies, loans, and debt Services.
Taxes: taxes that are treated as a direct transfer payment are those representing a
diversion of net benefit to the society. A tax does not represent real resource flow it
represents only the transfer of a claim to real resource flows. In financial analysis a tax
is clearly a cost. When a firm pays taxes its net income reduces. But the payment of
taxes does not reduce national income. Rather it transfers income from the firm to the
government so that this income can be used for social purposes presumed to be more
important to the society than the increased individual consumption (investment had the
firm retained the amount of the tax. So, in economic analysis taxes will not be treated
as a cost in project account.
119
No matter what form a tax takes, it is still a transfer payment-whether a direct tax or an
indirect taxes such as sales tax, an excise tax, or tariff or duty on an imported input for
production. Whether a tax should be treated as a transfer payment or as a payment for
goods and services needed to carry out the project or merely a transfer, to be used for
general purposes, of some part of the benefit from the point to the society as a whole.
Subsidies: are simply direct transfer payments that flow in the opposite direction from
taxes. Direct subsidies represent the transfer of a claim to real resources from one
enterprise, sector or individual to another. Subsidies may be open or disguised and are
provided on the input or out put side. On the input side subsidies reduce costs to the
project. If the subsidy is granted on the output side, i.e. increase the revenue of the
project; we should deduct the amount of the subsidy from the revenue that includes
subsidy. If a firm is able to purchase an input at a subsidized price that will reduce his
costs and thereby increase his net benefit, but the cost of the input in the use of the
society's real resources remains the same. The resources needed to produce the input
or to import it from abroad reduce the national income available to the society. Hence,
for economic analysis of a project we must enter the full cost of the input.
Credit Transactions: These are the other major form of direct transfer payments. A loan
represents the transfer of a claim to real resources from the lender to the borrower.
When the borrower repays loans or pays interest he is transferring the claim to the real
resource back to the lender-but neither the loan nor the repayment represent in itself,
use of the resources. In other words, the loan itself and its repayment are financial
transfers. The investment, however, or other expenditure that the loan finance involves
real economic costs. The financial cost of the loan occurs when the loan is repaid, but
the economic cost occurs when the loan is spent. The economic analysis does not, in
general, need to concern itself with the financing of the investment; that is, with the
sources of funds and how they are repaid.
The preceding rule is subject to one important exception. Although transfer payments
such as taxes and interest are not a source cost, they do have an impact on the
distribution of income and possibly on savings. And if the government wishes to use
project selection as a means of improving income distribution or increasing savings,
then this should be taken into account when determining the costs and benefits of a
project and should be reflected in the shadow prices of factor inputs and incomes.
120
 2.5. The cash flow in financial analysis
The three basic steps in determining whether a project is worthwhile or not are
(a) Estimate project cash flows
(b) Establish the cost of capital;
(c) Apply a suitable decision or appraisal rule or criterion.
Whether one is calculating financial or economic rate of return, a key part of the
analysis will be to work out the actual flows of income and expenditure. The financial
cash flow of a project is the stream of financial costs and benefits, or expenditures are
receipts that will be generated by the product over its economic life, and will not be
produced in its absence.
Note that when one is working with market prices, the cash flow stream is referred to as
financial cash flow. When these prices are adjusted to reflect national efficiency and
equity objective (i.e. When shadow prices are used) it is referred to as Economic Net
benefit stream and social Net benefit stream respectively.
In carrying out a financial cash flow, record year by year through out the expected life of
the project, all expected expenditure payments for goods and services for the project
(including capital expenditures) and all expected receipts from the project. For each
year, the subtraction of the former from the latter shows how much cash the firm gains
or loses as a result of the project. Borrowing and lending, and interest or dividend
payments, are normally excluded from the concept of " cash flow" when this is used for
the purpose of assessing the profitability of a new investment.
The difference between cash flow accounting and most forms of normal commercial
accounting are:
(i) In normal accounting income and expenditure represent the values of goods or
services delivered (some times in to stock) and received; not the cash received and paid
out for them.
(ii) Normal accounting shows financial liabilities, with respect to interest and tax, not
payments. There are sometimes large differences of timing here.
(iii) A financial allowance for depreciation and obsolescence of capital is made in
normal accounting. In cash flow accounting there is no such provision, but anticipated
renewals and replacements will be included as well as the scrap value of the equipment.
In financial cash flow, the total cost stream is subtracted from the total revenue to
121
obtain the financial in flow.
Example: Consider a project that has 20 years of estimated life. It is assumed that it will
take some years before the project yields some positive returns. The project starts
producing positive results only after year 1. Operation stops with no scrap value at the
end of year 20. Total cost starting at year 1 is birr 945 million, which increases to birr
1267 million in year 2.
Table1: Simple financial cash flow for x project (in million birr)
Cost Year
1 2 3 4 20
Capital Costs
Fixed assets
Pipes 400 500 300 0 -70
Pumps 50 100 90 0 -30
Storage tanks 140 230 160 0 -100
Jack hammers 20 10 0 0 -5
Construction 200 250 190 0 0
Total fixed assets 810 1090 740 0 -205
Working capital 20 30 40 0 -90
Total capital costs 830 1120 780 0 -295
Operating costs
Project management 80 100 120 90 90
Fuel 5 7 8 10 10
Maintenance 30 40 50 50 50
Total costs 945 1267 958 150 -145
Benefits (sales revenue) 0 200 250 500 500
Net benefits (benefits- -945 -1067 -708 350 645
costs)

Costs are typically broken in to investment and operating costs. The former basically
covers capital expenditure (such as plant and machinery) while the latter (incurred only
once the project is under way) is in turn divided into variable and fixed components. The
former covering such things as raw materials and labor inputs (which varies with out)
while the latter includes items such as maintenance, administration and managerial
charges (which will be relatively fixed with respect to volume of production).
For Financial analysis that is carried out from the point of view of the project entity, tax
and subsidy elements in cost (and revenue) components will be left in the calculation.
For financial analysis from national point of view, tax and subsidy elements will
normally be netted out of the calculation (Since these are transfer payments to and

122
from the government.) Depreciation will also be omitted, this being no more than an
accounting device for putting aside funds for replacement.
When detailed economic analysis is done the cost break down used in the standard
procedure will not be sufficient. We need to reclassify all project inputs and out puts
into traded and non-trade goods and basic factors of production. This is another part of
project analysis. Basic principles for measuring project cash flow. For developing the
stream of financial costs and benefits the following principles must be kept in mind.
 Incremental principle
The cash flow of the project must be measured in incremental terms. To ascertain a
project's incremental cash flows one has to look at what happens to the cash flows of
the firm with the project and with out the project. The difference between the two
reflects the incremental cash flows accounting of the project.
 Long term funds principle
A project may be evaluated from various point of views: total funds point of view,
long term funds point of view, and equity point of view. It is usually recommended that
project be evaluated from the point of view of the long-term funds (which are provided
by equity stock holders, preference stockholders, debenture holders and long term
lending institutions) because the principle evaluation is long-term profitability. Hence,
for determining the costs and benefits of an investment project we will have to ask what
is the sacrifice made by the suppliers of long term funds? And what benefits accrue to
the suppliers of long-term funds?
 Exclusion of financing costs principle
The exclusion of financing costs principle means that
(i) The interest on long-term debt is ignored while computing profits and taxes there on
and (ii) the expected dividends are deemed irrelevant in cash flow analysis. If interest on
long term debt and dividend on equity capital are deducted in defining cash flows, the
cost of long term funds will be counted twice, which is an error.
 Post-tax principle
Tax payments like other payments must be properly deducted in deriving the cash
flows, put differently cash flows must be defined in post tax terms.
Components of the cash flow stream
The cash flow stream associated with a project may be divided into three basic
123
components.
(a) An initial investment
(b) Operating cash in flows, and
(c) A terminal cash flow
The initial investment costs are defined as the sum of fixed assets (fixed investment
costs plus pre-production expenditures) and net working capital, with fixed assets
constituting the resources required for constructing and equipping an investment
project, and net working capital corresponding to the resources needed to operate the
project totally or partially. In short, the initial investment represents the relevant cash
flow when the project is set up.
The operating cash inflows are the cash inflows that arise from the operation of the
project during its economic life. The terminal cash flow is the relevant cash flow
occurring at the end of the project life on account of liquidation of the project.
Initial Investment:
The manner in which the initial investment is defined depends on whether the project is
a new project or a replacement project as shown below:
New project Replacement project
Cost of capital assets Cost of replacement capital cossets
+ Installation costs + Installation costs
+ Working capital margin - Post - tax proceeds from the sale of old
capital assets
+ Preliminary and pre-operative expenses + Change in working capital margin
- Tax shield, if any, on capital assets + Preliminary and pre-operative expenses
- Tax shield, if any, on replacement capital
assets.

Operating cash inflows: For deriving the operating cash inflows, the projected
profitability statements are the starting point. Since there is a difference between the
recognition of revenues and expenses in accounting and the incidence of cash flows, a
rigorous analysis requires that each item of revenue and expense be examined to find
out the cash flows associated with it. When we are interested in defining the cash flows
on a year basis, as is done commonly in project appraisal, a significant portion of such
detailed analysis is redundant because it helps in getting only a more refined picture of
intra-year cash flows. So from a practical point of view, it suffices if depreciation and
other non- cash charges, which are deducted in computing profits from the accounting
point of view, are added back because they do not result in cash out flows. This means
124
that the operating cash inflow for a given year is defined as flows.
New project Replacement project
Profit after tax Change in profit after tax
+ +
Depreciation Change in deprecation
+ +
other non-cash charges Change in other non-cash charges
+ +
Interest on long- term debt (1-tax rate) Change in interest on long term debt (1-tax
rate)

Terminal cash flows: The cash flow resulting from the termination or liquidation of a
project at the end of its economic life is called its terminal cash flow. It is defined as
follows:
New project Replacement project
Post-tax proceeds from the sale of capital Post-tax proceeds from the sale of
assets replacement capital assets.
+ +
New recovery of working capital margin - post - tax proceeds from the sale of old
capital assets
+
Net recovery working capital margin
* Post-tax proceeds are also referred to as the net salvage value.
Net Salvage value of capital Assets: Usually, the sale price of a capital asset exceeds its
book value. There fore, the net salvage value is equal to:
Sale value - Tax, if any, on sale
If however, a loss is incurred on sale, the net salvage value is equal to:
Sale value - Tax shield, if any, on sale.
It is difficult to estimate the sale value of a capital asset as it is influenced by factors
like technological innovations, inflation, shifts in demand, and physical wear and tear. In
view of these difficulties, an approach that is commonly followed is to assume that the
sale value would be equal to either the book value at the time of sale or a small fraction
(Say 5 percent) of the original value. Since this approach is rather naive and unrealistic,
the following method can be used to get a first approximation of the Sale value.
1. Find the ratio of the market price of a machine used for n years ( n is the
planning horizon ) to the market price of a new machine. Denote this by r.
2. Determine the annul compound rate of growth of the price of a new machine over

125
 the last five years. Denote this by "g".
3. Project the price of new machine after n years using the formula: A (1 + g) n
where, A represents the price of the new machine now.
4. Estimate the sale price of machine (bought new now) after n years of use,
employing the formula. A (1 + g) n. r
Example: A firm, having a planning horizon of ten years, is considering the acquisition of
a new machine, which costs birr 1.2 million now. The cost of a similar new machine five
years ago was birr 0.8 million. The market price of a comparable machine which has
been used for ten years is now birr 0.4 million. Given the above information, the sale
value of a new machine, now bought for 1.2 million, after ten years (the planning horizon)
is obtained as follows.
The ratio of the market value of a ten-year old machine to the market value of a new
machine is
4
r 
12

The annual compound rate of growth 4 in the price of a new machine is

1
12  5
g
 8  1  0 . 09  9 %
 

The sale price of a new machine after ten years is 1.2 million (1.09)10 = 2.4 million.
The sale price of a machine (bought new now) after 10 years of use would be equal to:
4
2.4 million x = 0.948 million
12

The equation for g is obtained as follows.

8 (1  g ) 13
5

12
So (1  g ) 
5

8
1
12  5

(1  g )  
8 

1
12  5

g   1
8 

126
Net recovery of working capital margin: Working capital is normally expected to be
liquidated at its face value. Hence no profit or gain is expected from its liquidation.
Therefore, the net recovery of working capital margin is equaled with the working capital
margin provided at the outset.
2.6. Investment Profitability Analysis
Once the Stream of costs and benefits for a project is defined in the form of cash flows,
the attention shifts to the issue of project worthwhile ness. A wide variety of project
appraisal criteria (or evaluation methods) have been suggested to judge the worthwhile
ness of capital projects. Some are general and applicable to a wide range of
investments; others are specialized and suitable for certain types of investments. The
more important and popular of these can be classified into two broad categories:
2.6.1. Non-discounted measures of project worth
Projects, which are powerful means of development, have to be appraised by multiple
criteria. In order to appraise a project idea we need operational criteria applicable in
evaluating alternatives. Technical criteria are used to compare the merits of alternative
technical solutions. It should be noted that there might be no one best technique for
estimating project worth although some may be better than others. We should also note
that these are only tools to improve decision-making. There are other non-quantifiable
and non-economic criteria for making project decisions. The tools are only used to
improve the decision making process. Before we discuss the discounted project
appraisal criteria we need to consider some common undiscounted measures.
1. Ranking by Inspection

It is possible, in certain cases, to determine by mere inspection which of two or more

investment projects is more desirable. There are two cases under which this might be
true.
(a) two investments have identical cash flows each year up to the final year of the short-
lived investment, but one continues to earn cash proceed (financial results or profits) in
subsequent years. The investment with the longer life would be more desirable.
Example: Consider the following hypothetical projects (Table 2.1)
Investment Initial cost Year I Year II
(project)
A 10,000 10,000 -
B 10,000 10,000 1,100
127
 C 10,000 5,762 7,762
D 10,000 7762 5,762
Accordingly project B is better than investment A, since all things are equal except that
B continues to earn proceeds after A has been retired. More analysis is required to
decide between C & D,
(b) Two investments have the same initial out lay (the total net value of incremental
production may be the same), the same earning life and earn the same total proceeds
(profits) but one project has more of the flow earlier in the time sequence, we choose
the one for which the total proceeds is greater than the total proceeds for the other
investment earlier. Thus investment D is more profitable than investment C, Since D
earns 2000 more in year 1 than investment C, which does not make up the difference
until year 2.
2. The payback period.

The payback period also called the pay off period is one of the simplest and apparently
one of the most frequently used methods of measuring the economic value of an
investment. The payback period is the length of time required to recover the initial cash
out lay on the project.
Example: If a project requires an original out lay of birr 300 and is expected to produce a
stream of cash proceeds of birr 100 per year for 5 years, the pay back period would be
300 3 years
100

Note: If the expected proceeds are not constant from year to year, then the payback
period must be calculated by adding up the proceeds expected in successive years until
the total is equal to the original out lay.
As observed in table 2.1 above, investment A and B are both ranked as 1, since they
both have shorter pay back periods than any of the other investments, namely 1 year.
But investment B which has the same rank as A will not only earn 10,000 birr in the first
year but also 1, 100 birr a year later. Thus, investment "B" is superior to "A". But a
ranking procedure such as the payback period fails to disclose this fact. Thus, it has
two important limitations:
(i) It fails to give any considerations to cash proceeds earned after the pay back date. It
simply emphasizes quick financial returns
128
ii) It fails to take into account differences in the timing of receipts and earned proceeds
prior to the payback date. For instance, if we have two projects with the same capital
cost and if they have the same pay back period then they are equally ranked. Yet we
know by the inspection method the project with more earlier benefits should be
desirable and should be preferred since the earlier a benefits is received the earlier it
can be reinvested or consumed.
3. Proceeds per unit of outlay

Under this method, investments are ranked according to their total proceeds divided by
the amount of the corresponding investments.
Example: consider the following hypothetical example
Investment Total proceeds Investment Proceeds per Ranking
Unit of outlay
A 10,000 10,000 1.00 4
B 11,100 10,000 1.11 5
C 11,524 10,000 1.15 1
D 11,524 10,000 1.15 1

Accordingly project C and D must be implemented. However, both projects are given the
same rank. Although we know by inspection method that project D is superior because
D generates birr 2000 of proceeds in year 1. This method is a gain deficient because it
still fails to consider the timing of proceeds
4. Out put capital Ratio

It is defined as the averages (un discounted) value added produced per unit of capital
expenditure. Under this criterion we select the project with the highest out put capital
ratio or the lowest capital out put ratio.
2.6.2. Discounted measures of project worth
The undiscounted measures discussed so far share common Weakness. They fail to
take into account adequately the timing of benefits. Thus, it is an accepted principle in
economics that inter-temporal variations of costs and benefits influence their values
and a time adjustment is necessary before aggregation. Therefore a time dimension
should be included in our evaluation. That means we need to express costs and
benefits in terms of value by discounting all items in the cash flows back to year 0. The
need for such a procedure will be apparent if one considers the following simple

129
argument.
Suppose one is offered the choice between receiving birr 100 today and receiving the
same amount in a year's time. It will be rational to prefer to receive the money today for
several reasons.
a) One may expect inflation to reduce the real value of birr 100 in a year's time

b) If there were no inflationary effect, it would still be preferable to take the money
today and invest it at some rate of interest, r, hence receiving a total of birr 100
(1+r) at the end of the year.

c) Even if no investment opportunities are available, one might reason that birr 100
today would still be preferable on the grounds that there is a finite risk to collect
the money next year.

d) Even where inflation, investment opportunities and risk are ignored, there is pure
time preference, which would lead one to prefer the immediate offer.

For all these reasons we say there is a positive rate of discount, which leads us to place
a lower present value on a given sum of money the further in the future one expects it to
accrue. The accepted method for this adjustment amounts to bringing them to a
common time denominator. This principle is called discounting.
Discounting is a technique or a process by which one can reduce future benefits and
costs to their present worth or present value. This is the method used to revalue future
cost and benefits are discounted by a factor that reflects the rate at which today's value
of a monetary unit decreases with the passage of every time unit.
Any costs and benefits of a project that are received in future periods are discounted, or
deflated by some factor, r, to reflect their lower value to the individual (society) than
currently available income. The factor used to discounted future costs and benefits is
called the discount rate and is usually expressed as a percentage. Hence, discounting is
very important for project analysis. The discount rate is usually determined by the
central authorities.
Note that in order to clearly understand the principles of discounting it will be helpful to
have a clear understanding of the principle of compounding. Compounding is the
technique of calculating the future worth (F) of a present amount (P) at the end of some
130
period T at a given interest rate. On the other hand finding the present worth of a future
Stream of value is called discounting. Hence, if there is an initial amount p at present,
then if this investment was borrowed from the bank at an interest rate of "r" birr then
after one period it becomes:
P + Pr = P (1+r) - since the borrower must also repay the principal
After two periods the amount becomes:
P + Pr +r (p + pr)
P + Pr +Pr + pr2
P + 2Pr + pr2
P (1+ 2r +r2
P [ (1+r) (1+r)] = P (1+r)2
In general, the amount accumulated after t periods would be A = P (1+r) t
Now given that future value accumulated after t periods as above, if we want to know
the present value of this amount we would be taking about discounting. Hence the
present value would be:
A amount . . accumulate d at some future date t
P    A (1  r )
(1  r ) (1  r )
t t

A. The Net present value (NPV)

The most widely used and straightforward discounted measure of project worth is the
net present value (NPV). This value is obtained when a stream of cost and benefits
accruing over a period of time are discounted to the present is called the present value
of the stream. The NPV is defined as the difference between the present value of
benefits and the present value of costs. The NPV can be obtained by discounting
separately for each year, the difference of all cash outflows and inflows accruing
through out the life of project at a fixed, pre determined interstate rate.
The net present value formula is:
B0  C 0 B1  C 1 B 2  C 2 Bn  C n n ( Bt  Ct )
NPV    ... 
(1  r ) (1  r ) (1  r ) (1  r ) t  0 (1  r )
0 1 2 n t

Where Bt are the project benefits in period t.

Ct is the project costs in period t.
r is the appropriate financial or economic discount rate
n is the number of years for which the project will operate
The discounted rate should be equal either to the actual rate of interest on long term
loans in the capital market or to the interest rate paid by the borrower. However, since
capital market do not usually exist in developing countries, the discount rate should
131
reflect the opportunity cost of capital i.e. the possible return of capital invested
elsewhere. This is the minimum rate of return below which the planner considers that is
does not pay for him to invest.
The discounting period should normally be equal to the life of the project. This period is
the economic life of the project and varies from project to project.
Having set the discount rate, an investment project is deemed acceptable if the
discounted net benefits (benefits minus costs) are positive. The economic criterion of
project appraisal is to accept all projects that show positive NPV at the predetermined
discount rate and reject all projects that show Negative NPV. Thus, the decision is to
accept if NPV > 0. We can also discount benefits and costs separately, and if B>C then
NPV >0.
Example: consider the following discounted cash flow for the hypothetical project in
million birr.
Year Cash flow Discounted Discounted cash Discounted Discounted
factors for flow (10%) factor for 20% cash flow
10 % (20%)
0 -20 1.00 -20.0 1.00 -20.0
1 4 0.909 3.64 0.833 3.33
2 4 0.826 3.30 0.694 2.78
3 4 0.751 3.00 0.579 2.32
4 4 0.683 2.73 0.482 1.92
5 4 0.621 2.48 0.402 1.61
6 4 0.564 2.26 0.335 1.34
7 4 0.513 2.05 0.279 1.12
8 4 0.467 1.87 0.233 0.93
9 4 0.424 1.70 0.194 0.78
10 4 0.386 1.54 0.162 0.65
NPV 4.57 -3.21

Since discounting the cash flow at 10 percent produces a positive NPV of 4.57 million
birr. We conclude that the project should be under taken. Suppose now that cost of
capital was to be raised to 20 percent, the project produces a negative NPV of 3.21
million birr. In this event the project would have to be rejected.
Decision rule for Mutually Exclusive projects
A mutually exclusive project is defined as a project of that can only be implemented at
the expense of an alternative project as they are in some sense substitutes for each
other. The decision rule for such projects is to accept the project with the highest NPV.
Example: Consider two hypothetical dams, which may be proposed for one prime site in
a locality in a fast flowing river (in million birr).
132
 Years
Dam A 1 2 3 4 5 6 7 8 9 10
Cost 3
Benefits 0 1 1 1 1 1 0.5 1
Net benefits -3 1 1 1 1 1 0.5
NPV = 1 million
Years
Dam B 1 2 3 4 5 6 7 8 9 10
Cost 500
Benefits 0 100 100 100 100 100 100 100 100 100
Net benefits -500 100 100 100 100 100 100 100 100 100
NPV = 33 million
If the two projects were independent and there was no budget constraint, the country
could there fore construct both, and then it should do so as they both have positive
NPVS. However, Since the projects are mutually exclusive the dam with the higher NPV
should be selected, that is dam B.
Practical application for the present value method.
The practical application of the present value criterion as a means of evaluating
investment proposals for project planning implies the following assumptions.
a) Annual out lays and receipts from each investment are known for the entire life
of the project
b) That the project life span is known
c) That there is a rate of discount, which can be applied to every proposal and for
every time period.
However, the information required (the assumptions) made above is not always
available for every project. That means the NPV criterion may be applicable only to a
limited number of project proposals on which relevant data as indicated above could be
computed or imputed.
Advantages of NPV method
Conceptually sound, the net present value selection criteria has considerable merits:
 It is simple to use and does not rely on complex conventions about where costs
and benefits are netted out.
 It is the only selection criteria that can correctly be used to choose between
mutually exclusive projects, with out further manipulation

133
  It takes in to account the time value of money
 The net present value of various projects, measured as they are in today's birr,
can be added. For example, the net present value of a package consisting of two
projects, A and B, will simply be the sum of the net present value of this projects
individually:
NPV (A+ B)=NPV (A)+NPV (B)
Limitations of the Net present value method
 Some projects could be deferred from implementation although they show positive
NPV, due to scarcity of funds. Thus passing the NPV test may be a necessary
condition but not a sufficient condition
 If some projects were mutually exclusive then the implementation of one would
naturally exclude the execution of the other. This will lead both the central
authorities and the sponsoring agency in to a dilemma which project should be
implemented. If funds are unlimited then both could be implemented, but this is not
always the case
 The selection of an appropriate discount rate is another limitation
 It does not show the exact profitability rate of the project.
B. The Internal Rate of Return of a project (IRR)
The internal rate of return of a project is the discount rate, which makes its net present
value equal to zero. The method utilizes present value concept but seek to avoid the
arbitrary choice of a discount rate. Hence an attempt is made to find that discount rate
which just makes the net present value of the cash flow equal to zero. It is possible to
think a level of interest rate that could result in NPV of zero. This rate of interest rate is
termed as the Internal rate of return (IRR). The IRR is the rate of discount, which makes
the present value of the benefits exactly equal to the present value of the costs.
( BtC t
NPV 0 
(1  r )
t

For financial analysis it would be the maximum interest rate that the project could
afford to pay on its funds and still recover all its investment and operating costs. While
calculating the NPV we have used a pre determined discount rate and a table. But the
calculation of the IRR amounts to Searching for the discount rate that gives a zero NPV.
This is achieved through trial and error using the standard discounting table.
134
To illustrate the calculation of internal rate of return, consider the cash flows of a
project:
Year Cash flow
0 -100,000
1 30,000
2 30,000
3 40,000
4 45,000
The internal rate of return is the value of r, which satisfies the following equation
 100 , 000 30 , 000 30 , 000 40 , 000 45 , 000
0     
(1  r ) (1  r ) (1  r ) (1  r ) (1  r )
0 1 2 3 4

30 , 000 30 , 000 40 , 000 45 , 000

100 , 000    
(1  r ) (1  r ) (1  r ) (1  r )
1 2 3 4

We try different values of r till we find that the right-hand side of the above equation is
equal to 100,000. Let us, to begin with, r = 12 percent.
30 , 000 30 , 000 40 , 000 45 , 000
1
 2
 3
 4
 107 , 773
(1 . 12 ) (1 . 12 ) (1 . 12 ) (1 . 12 )

Since this is more than 100,000, we have to try a higher value of r. (In general, a higher r
lowers the right-hand side value and a lower r increases the right-hand side value.) Let r
= 14%
30 , 000 30 , 000 40 , 000 45 , 000
1
 2
 3
 4
 103 , 046
(1 . 14 ) (1 . 14 ) (1 . 14 ) (1 . 14 )

Since this value is higher than the target value of 100,000, we have to try a still higher
value of r. Let r = 15%
30 , 000 30 , 000 40 , 000 45 , 000
1
 2
 3
 4
 100 , 802
(1 . 15 ) (1 . 15 ) (1 . 15 ) (1 . 15 )

This value is a shade higher than our target value, 100,000. So we increase the value of r
from 15% to 16%. The right-hand side becomes:
30 , 000 30 , 000 40 , 000 45 , 000
1
 2
 3
 4
 98 , 641
(1 . 16 ) (1 . 16 ) (1 . 16 ) (1 . 16 )

Since this value is now less than 100,000, we conclude the at the value of r lies between

135
15 percent and 16 percent
At 15 percent, the present value is 100,802
At --? Percent, the present value is 100,000
At 16 percent, the present value is 98,641
1 percent difference (between 15 percent and 16 percent) corresponds to difference of
2, 161= (100802-98641). The difference between 100,802 (present value at 15 percent)
and 100,000 (target present value) is 802. This difference will correspond to a
802
percentage difference of: x 100  0 . 37 percnet
2161

Adding this number to 15 percent, we get the interpolated value as 15.37 percent.
Note: If the positive and negative NPVs are close to zero, a precise and less time
consuming way to arrive at the IRR uses the following interpolation formula
Pv ( I 1  I 2)
IRR I1 
Pv  Nv
Where: I1 = the lower discount rate
I2 = the upper discount rate
Pv=NPV (positive) at the lower discount rate of I1
NV = NPV (negative) at the higher discount rate of I2
Note: I1 and I2 should not differ by more than one or two percent.
802 (16  15 ) 802
IRR 15   15   15 . 37 %
802 1359 2161

Another approximate solution to IRR is to plot the NPVs corresponding to several

discount rates to give what we call the NPV curve. The present values are plotted on the
Y - axis and the discount rates on the x-axis. A curve is then drawn to connect the
various points on the graph. The point at which the curve cuts the x-axis represents the
rate at which the present value of the investment is equal to zero.
Example: By experimenting with discount rates between 10 and 20 in our hypothetical
project, the IRR for the project is fractionally above 15%.
Decision rule for independent projects
According to the IRR Version of economic criterion we implement all projects that show
an IRR greater than the predetermined discount rate (opportunity cost of capital), i.e.

136
accept all independent projects having an IRR greater than the opportunity cost of
capital (cut off rate). The reference discount rate, which is also called the target rate, is
predetermined by the central bank. Once the IRR is identified, the decision rule is accept
the project if the IRR is greater than the cost of capital, say Y. Note also that:
When NPV > 0 then IRR > r
NPV = 0 then IRR = r
NPV < 0 then IRR < r
All projects with an internal rate of return greater than some target rate of return r,
should be accepted. The target rate is usually the same rate used as the financial or
social discount rate employed in the computation of the projects net present value.
The IRR and mutually Exclusive projects
While the IRR cannot be directly used to choose between mutually exclusive projects it
can be employed for further manipulation. This manipulation entails the subtracting the
cash flow of the smaller project from the cash flow of the larger one and calculating the
internal rate of return of the residual cash flow. It the residual cash flow's internal rate
of return exceeds the target discount rate, which could only occur if the larger project
has a higher NPV, then the larger project should be under taken.
Comparison of the NPV and IRR
Form the foregoing discussions it is clear that both the NPV and the IRR methods can
and do rank investment projects in more rational manner than the other methods
previously considered. Thus it is advisable to calculate these measures so that easily
understandable information is provided to the authorities. In general it can be said that
the NPV method is simpler, easier, and more direct and more reliable.
In some situations both the NPV and the IR criteria give the same accept- reject
decision. However, there are two probable reasons why all acceptable projects cannot
be under taken. One is that inventible funds (capital funds) may be limited. The second
real problem is that the discount rate has not been set correctly.
When the capital requirements of all acceptable projects exceed the available funds, the
central authorities should raise the discount rate up to that level where the projects
passing the test are just enough to exhaust the available funds. But if too few projects
are acceptable then the discount rate should be reduced. Hence as long as capital
funds are "unlimited" it is argued that NPV should be the relevant criterion. But the

137
function of the discount rate is to ration capital in such a manner, as eventually to pass
just sufficient projects as well use up available investment resources. Hence the
argument is not whether NPV or IRR should be preferred as a criterion, but whether
planners have set the discount rate correctly.
The IRR and NPV might suggest different projects for similar level of discount rate.
Example: cash flows for a hypothetical project.
Cash flows
Year Project A Project B Project C
0 -20 -40 -20
1 4 8 14
2 4 8 14
3 4 8 -
4 4 8 -
5 4 8 -
6 4 8 -
7 4 8 -
8 4 8 -
9 4 8 -
10 4 8 -
NPV at 10% 4.57 6.08 4.36
IRR 15.1% 13.7% 25.8%
As it can be observed from the table above the three projects by their NPVs (at 10%
discount rate) results in project B heading the list, while ranking them according to their
IRRs would lead the planners to prefer C. 25.8% is better because a project with 25.8%
economic rate of return is likely to a better investment than with a project with 15%
economic rate of return. That is, it contributes more to the national income relative to
the resources used.
There are two possible reasons for not to undertake all the above projects.
The first is there may not be enough capital funds the second problem is related to the
fact that two or more projects could be mutually exclusive. If there is enough budget
resources, both NPV and IRR give the same accept-reject decision. However, ranking
the projects using the two methods will lead to the choice of different projects: project
B on NPV basis and project C on the IRR basis.
Note however, that 10% is not an appropriate discount rate because it passes all the
three projects more than can be accommodate by the given capital. Hence we have to
set the discount rate correctly up to the level where the project passing the test are just
138
enough to exhaust the available funds as shown below.
Project A B C
NPV 15% 0.08 -1.84 2.76
NPV 10% 4.57 6.08 4.36
NPV 20% -3.23 -7.75 1.39
In general if funds are unlimited and the projects are not mutually excusive, the NPV is
the relevant criteria. All projects with positive NPV should go a head. But, the function of
the discount rate is to ration capital in such a way that eventually to pass just sufficient
projects that will exhaustively use up available inevitable funds. Thus, the important
question is not whether NPV or IRR is to be preferred, but whether planners have set the
discount rate correctly or not.
Example:
Assume that the total investment budget is birr 80 million. The projects above are all
projects in the economy. In this case planners can implement all projects. If the budget
is birr 40 million however can implement all projects. If the budget is birr 40 million
however, the planner has to make the choice of carrying B alone or A and C together.
Since the combine NPV of A and C is larger B is the least choice at 10 discount rate.
Advantages of the IRR
1. The IRR is used in many projects

2. It is the only measure of project worth that takes account of the time profile of a
project but can be calculated with out reference to a predetermined discount rare.

3. It is a measure that could be understood by non-economists since it is closely

related to the concept of the return on investment

4. It is a pure number and hence allows projects of different size to be directly

compared.

Problems with the IRR

1. The IRR is inappropriate to use for mutually exclusive projects and independent
projects when there is a single period budget constraint.

2. A project must have at least one negative cash flow period before it is possible to
calculate its internal rate of return. This is because the NPV will always be positive

139
 to matter how high the discount rate used to discount it, unless the project has at
least one negative cash flow period.

3. Certain cash flows can generate NPV = 0 at two different discount rates. If a project
has more than one IRR, then neither can be reliably used and another decision rule
such as the NPV must be used rather than the IRR.

. The following cash flows generates NPV = 0 at both (-50% & 15.2%)
Co C1 C2 C3 C4 C5 C6
-1000 + 800 + 150 + 150 + 150 + 150 - 150
C. The Net Benefit Investment Ration (NBIR)
It is the ratio of the present value of the projects benefits, net of operating costs, to the
present value of its investment costs. This is given by,
n
( Bt  OC
NBIR  
t 0 (!  r )
t
t

IC
 (1  r ) t
t

Where OC is operating costs in period t; IC is investment costs in period t; r the

appropriate discount rate, and B the benefits in period t. The NBIR shows the value of
the projects discounted benefits, net of operating costs, per unit of investment.
The decision rule using NBIR is to accept the project if its value is greater than 1. This
criterion is especially important for ranking investments that shows the benefit per unit
of investment. When we have a single period budget constraint projects with the highest
NBIR should be selected up to the point where the budget exhausted.
The main advantage of the NBIR is its capacity to determine the group of priority
projects if there is a single period budget and investment constraint. Its limitation is
how ever, that it is not suitable for choosing between mutually exclusive projects, for the
same reason that the IRR cannot be used for this purpose. That is a project with highest
NBIR could have the lowest absolute net present value. The other disadvantage of NBIR
is that the convention used for dividing costs in to operating and investment may vary
from institution to institution and may render problems of comparability.
D. The Domestic Resource cost Ratio (DRCR)
140
In its simple form the DRCR is an discounted measure of project worth calculated for a
single typical year of project operation. It is given as
( C t 1  B t 1)
n

 0 (1  r )
t
( birr )

t
DRCR n
Ct f  Bt f )

t 0 (1  r )
t

Where Bt1 are the benefits of the project obtained in local currency
Ct1 are the costs of the project incurred in local currency
Btf are the benefits of the project obtained in foreign exchange
Ctf are the costs of the project incurred in foreign exchange.
The decision rule for DRCR
When undertaking a financial appraisal a project should be accepted if its DRCR is less
than or equal to the official exchange rate, OER. This means a project should proceed if
it uses less domestic resources, measured in local prices, to earn 1 unit of foreign
exchange than is the norm for the whole economy (the norm here being represented by
the official exchange rate.) The modified DRCE (Modified because it is discounted
which traditionally was not the case) is some times referred as the internal exchange
rate approach to emphasize the fact that the computation of DRCR is independent of
any predetermined exchange rate as that of IRR, which do not immediately, require a
discount rate. It produces own internal exchange rate, which is internal to the project.
Example. Estimation of the domestic resource costs ratio, special economic zone
project -foreign exchange component (denominator) million us dollar.
Year
1 2 3 4 5 6 7 30
Local costs
Investment 40 60 30 10
Production 0 50 75 90 100 100 100 100
Total local costs 40 110 105 100 100 100 100 100
Local Sales 0 0 20 25 25 25 25 25
Net local costs 40 110 85 75 75 75 75 75
PV of net local Birr 711.6
costs
Year
1 2 3 4 5 6 7 30
Foreign exchanger earnings
Exported output 0 3 20 30 30 30 30 30

141
Foreign exchange costs 2
Imported investment goods 20 40 12 8 10 10 10 10
Other imported items 0 5 7
Net foreign exchange - -42 1 20 20 20 20 20
earnings (expert-imports) 20
PV of net foreign exchange Us $ 86.7
earnings

DRCR = Pv net local costs / PV of net foreign earnings = Birr 711.6 / US $ 86.7 = 8.21
birr per US $
The main advantage of this approach is that non-economists can readily understand its
decision rule. More substantially in economics with serious balance of payment
problem the DRCR clearly show the potential of a project to earn foreign exchange.
However, its disadvantages includes, like that of IRR it cannot be used to rank projects.
It cannot also be used to choose between mutually exclusive projects if both use less
domestic resource to earn a unit of foreign exchange. This is because it does not show
which of the two, or more, mutually exclusive projects will generate the greatest net
benefits for the country.
E. The Benefit cost Ration (BCR)
The BCR is defined as the ratio of the sum of the project's discounted benefits to the
sum of its discounted investment and operating costs. This is given as
n
Bt
 (1  r )
0
t


t
BCR n
Ct
 (1  r )
t 0
t

The Decision rule for BCR

A project should be accepted if its BCR is greater than or equal to 1 (i.e. if its discounted
benefits exceed its discounted cost)
2.7. Sensitivity analysis
Sensitivity analysis shows how the value of the efficiency criterion Net present value,
Net national value added or any other criterion changes with variations in the value of
any variable (sales volume, selling price per unit,cost per unit etc).
It may be expressed as the absolute change in the efficiency criterion divided by a given
percentage or absolute change in a variable or set of variables. Thus, one may say

142
cutting in half the selling price of the output will make the value added zero. If the value
added is sensitive to the variables, the project is sensitive to uncertainties and special
care should be devoted to making precise estimates, particularly of those variables the
estimated values of which may contain significant errors.
Sensitivity analysis may be used in early stages of project preparation to identify the
variables in the estimation of which special care should be taken. In practice it is not
necessary to analyze the variations of all possible variables. It is sufficient to confine
the analysis to the key variables affecting the project the most, are expected to vary
considerably below or above the most likely magnitude. If value added is insensitive to
the value of a particular input or output, the project is said to be insensitive to
uncertainties and there is little point in trying to estimate this variable with great
precision. Sensitivity analysis provides a better understanding of which variable is in
fact crucial to the project's appraisal. Such analysis will also be helpful for those in
charge of managing the project later. It will indicate critical areas requiring close
managerial attention in order to ensure the commercial success of a project.

Chapter Three: Economic Analysis of Projects

1.1 An overview of economic analysis

In financial analysis, the analyst is concerned with the profitability of the project from an
individual point of view (firm’s profitability). The main objective here is to maximize the
income of the firm or to analyze the budgetary impacts. In financial analysis the
analysis is done by applying market prices. Given the prevailing market prices the
financial analysis will tell the project analyst whether a project will be financially
profitable.

Thus, governments and individuals can pursue only limited objectives when they choose
projects on the basis of financial appraisal. From the standpoint of the economy as a
whole, however, the objective is to maximize national income no matter who receives it.
But financial analysis will rarely measure a project’s contribution to the community’s
welfare. Only in very unlikely conditions of perfect competition and absence of
externalities, government interventions, taxes and other market distortions, will financial

143
analysis of a project indicate whether or not a project will make a positive contribution
to society’s welfare. In the absence of these conditions, a financial analysis will only tell
us whether a project is profitable or not. Thus the project analyst must not only be sure
that a proposed project will be profitable enough to attract investment but also that the
project will contribute sufficiently to the growth of national income. Making that
assessment is the task of economic analysis.

What is the starting point for this analysis? The starting point for the economic analysis
would be the financial prices. They are adjusted as needed to reflect the value to the
society as a whole of both the inputs and outputs of the project.

The objective of any legitimate government should be the promotion of

social/community/ welfare. They will be more concerned with their public work
programs to promote community welfare than they merely maximize financial profits at
distorted local prices.

The basic question here is whether it is possible to use market prices to assess the
economic worth of projects. The answer is obviously no. Prices could be distorted
because of many factors. So governments must choose projects on the basis of an
economic analysis if they wish to promote the community’s welfare.

It is useful to have a fuller understanding of the areas where government intervention

and market failure result in serious distortion in market prices. This will help in
understanding the process of correcting for these distortions when economic prices are
used.

The major conditions under which it is impossible to use market prices to assess the
economic worth of projects can be grouped under the following major headings:

1. Intervention in and failures of goods markets including the markets for

internationally traded goods.

2. Intervention in and failure of factor markets including the market for labor,
capital, and foreign exchange.

3. The existence of externalities, public goods and consumer and producers

surplus.

144
 4. Imperfect knowledge, which the neoclassical model assumes that consumers
and producers have full knowledge of about all aspects of the economy relevant
to their choice of operations. This is unrealistic because of poor transport and
communication and low education levels.

Social Cost Benefit Analysis/Economic analysis is done because of the following

reasons:

1. Inflation: When high degree of inflation prevails in any economy, the project's
inputs and outputs do not reflect their real value.

 Therefore, the price of these inputs and outputs should be adjusted

2. Currency over valuation: when the foreign currency is over valued (eg, dollar), it
does not reflect the situation prevailed in the market

3. Existence of income/wealth inequality: due to this inequality price may not

reflect the social equalities. As a result project analysts shift to apply social
pricing techniques (that is shadow pricing techniques).

4. Externalities: are costs and benefits to the economy as a whole. Since they are
not paid for by a particular firm, financial analysts ignore them. But someone has
covered their cost (government), thus their value should be included in the
economic pricing technique.

5. Existence of tariffs, customs and duties: existence of these restrictions and

impositions by the government may increase the price of commodities.

6. This cost needs to be excluded in the economic analysis because it does not
reflect the commitment of real resources.

7. Existence of under employment: Unskilled and semi-skilled labor market is

highly affected because workers are paid less and

8. the payment of employees not the same for all doing the same job. Therefore, for
economic analysis purpose this distortion should be adjusted.

9. The existence of the above mentioned factors demands economic analysis so

that the value of inputs and outputs of a project can reflect its real value.

145
Common features of Financial and Economic Analysis

The economic analysis of a project has many features in common with a financial
analysis.

1. Both involve the estimation of a project’s cost and benefits over the life of the
project for inclusion in the project’s cash flow.

2. In both the cash flow is discounted to determine the project’s net present value,
or other measures of project worth

Both may also use sensitivity or probability analysis to assess the impact of uncertainty
on the project’s NPV.
Distinction Between Financial and Economic Analysis

Financial analysis looks at the project from the perspective of the implementing agency.
It identifies the project's net money flows to the implementing entity and assesses the
entity's ability to meet its financial obligations and to finance future investments.
Economic analysis, by contrast, looks at a project from the perspective of the entire
country, or society, and measures the effects of the project on the economy as a whole.
These different points of view require that analysts take different items into
consideration when looking at the costs of a project, use different valuations for the
items considered, and in some cases, even use different rates to discount the streams
of costs and benefits.

Financial analysis assesses items that entail monetary outlays. Economic analysis
assesses the opportunity costs for the country. Just because the project entity does not
pay for the use of a resource, does not mean that the resource is a free good. If a
project diverts resources from other activities that produce goods or services, the value
of what is given up represents an opportunity cost of the project to society. Many
projects involve economic costs that do not necessarily involve a corresponding money
flow from the project's financial account.

For example, an adverse environmental effect not reflected in the project accounts may
represent major economic costs. Likewise, a money payment made by the project entity
--say the payment of a tax--is a financial but not an economic cost. It does not involve
the use of resources, only a transfer from the project entity to the government.

146
Finally, some inputs—say the services of volunteer workers--may be donated, entailing
no money flows from the project entity. Analysts must also consider such inputs in
estimating the economic cost of projects.

Another important difference between financial and economic analysis concerns the
prices the project entity uses to value the inputs and outputs. Financial analysis is
based on the actual prices that the project entity pays for inputs and receives for
outputs. The prices used for economic analysis are based on the opportunity costs to
the country.

The economic values of both inputs and outputs differ from their financial values
because of market distortions created either by the government or by the private sector.
Tariffs, export taxes, and subsidies; excise and sales taxes; production subsidies; and
quantitative restrictions are common distortions created by governments. Monopolies
are a market phenomenon that can either be created by government or the private
sector. Some market distortions are created by the public nature of the good or service.
The values to society of common public services, such as clean water, transportation,
road services, and electricity, are often significantly greater than the financial prices
people are required to pay for them. Such factors create divergence between the
financial and the economic prices of a project.

But an economic analysis goes beyond a financial analysis appraisal, as it will also
involve adjustments and incorporating of imputed items. Economic analysis is an
iterative process that normally begins with a "with out the project" situation, which is
the baseline against which all alternatives are compared.Through a process of
successive approximations, the analyst defines alternatives, drops poor project
components, includes new components, examines the alternatives from financial and
economic points of view, compares them with the baseline and with each other, and
modifies them until a suitable and optimal project design emerges. The comparison
finally sheds light on the size and incidence of the environmental externalities that can
be evaluated in monetary terms.

Table 3.1: difference between economic and financial analysis

Factors Financial Economic

147
 Analysis Analysis
Pricing of inputs Domestic Shadow prices
market price
Treatment of transfer All included Excluded
payments, tax, subsidy, etc
Externalities Excluded Included

3.2. Shadow Prices and Conversion Factors

 Observed prices (used in the financial analysis) may not necessarily reflect the
true economic value of inputs and outputs.
 This may occur where:
 Prices of inputs and outputs are distorted because of inefficient markets;
and
 Governments impose tariffs that are non-reflective of costs.
For example, for illustrative purposes let us assume that there is only one cement
manufacturer in a country.
 Let us also assume no price regulation in this sector.
 Let us also assume a scenario whereby the producer is able to set the price of
cement at 20% higher than world markets and transport cost.
 In economic appraisal the ‘true’ cost of this production input (i.e. cement) should
be reduced by 20%.
 In practice, estimating these types of distortions is difficult and in general the
market price should be taken as the economic price.

For Which Items to Have Shadow Prices used in Economic analysis?

The inputs and outputs for which one has to have shadow prices can be categorized
into five categories, at least according to the “National Economic Parameters and
Conversion Factors for Ethiopia, Ministry of Economic Development and Finance, 1998”..

1. Primary factors. There are different categories of labour, land, natural resources,
domestic resources and foreign exchange. Land and natural resources are
usually valued indirectly through estimation of their productivity in their
alternative uses rather than as capital values. This is normally done through
taking the ‘with-out project situation’ rather than through adjustment of prices.

148
 For this reason there is no national parameter calculated for land.

2. Tradable goods(alternatively referred to as traded goods): This is undertaken

when there is a significant difference between the border price and the local
market price and/or where the item concerned is likely to feature prominently as
an input or an output for a number of projects.
3. Non-tradable goods(alternatively referred to as non-traded). Where there may be
a significant difference between the local market price and the economic value
and/or where the item concerned is likely to feature prominently as an input or an
output for a number of projects.
4. Average Estimates relating to particular sectors: here cost data do not allow
further breakdown or where the sector concerned is not a high priority for further
investigation. Important average is the standard conversion factors.
5. The Discount rate– the rate at which the future streams of costs and benefits
are brought into common denominator, the present values.
1.2 Identification costs and benefits of economic analysis
Identifying costs and benefits is the firstand most important step in economic analysis.
Often project costs and benefits are difficult to identify and measure, especially if the
project generates side effects that are not reflected in the financial analysis, such as air
or water pollution. A secondimportant step is to quantify them. The final step is to value
them in monetary terms.

The major steps in economic analysis can be summarized as:

1. Identification of cost and benefit items that need to be incorporated in economic

analysis; This involves the inclusion of some variables and exclusion of others
from the economic accounts.

2. Quantify both the cost and benefit items;

3. Revalue the cost and benefit items; i.e. what prices to use?

The projected financial revenues and costs are often a good starting point for
identifying economic benefits and costs, but two types of adjustments are necessary.

 First, we need to include or exclude some costs and benefits.

149
  Second, we need to revalue inputs and outputs at their economic opportunity
costs.

1.2.1 Sunk cost

For both financial and economic analysis, the past is the past. What matters are future
costs and future benefits? Costs incurred in the past are sunk costs that cannot be
avoided. When analyzing a proposed project, sunk costs are ignored. Economic and
financial analyses consider only future returns to future costs.

Ignoring sunk costs sometimes leads to seemingly paradoxical, but correct, results. If a
considerable amount has already been spent on a project, the future returns to the
costs of completing the project may be extremely high, even if the project should never
have been undertaken. As a ridiculous extreme, consider a bridge that needs only one
dollar to be completed in order to realize any benefits. The returns to the last dollar may
be extremely high, and the bridge should be completed even if the expected traffic is too
low to justify the investment and the bridge should never have been built in the first
place. However, arguing that a project must be completed just because much has
already been spent on it is not valid. To save resources, it is preferable to stop a project
midway whenever theexpected future costs exceed the expected future benefits.

On the other hand, although stopping a partially completed project may be more
economical than finishing it, closing a project is often costly. For example, one may
have to cancel partially completed contracts, and lenders may levy a penalty. Such
costs have to be taken into account in deciding whether or not to close the project.
Similarly, the cash flow of a project should show some liquidation value at the end of
the project. This liquidation value should be counted as a benefit. Sometimes, to focus
attention on the years for which the information is more reliable, we use the estimated
liquidation value of a project as of a certain year.

1.2.2 Transfer payments, externalities and others

Transfer payments (-) :In general terms, analysts need to remove all subsidies and
taxes from the financial flows. The analyst must eliminate (deduct) transfer payments
within the economy from theproject’s cash flow.In other words the transfer is made
without any exchange of goods and services. Exclude it from economic analysis.

150
Transfer paymentsare considered to non-exhaustive because they do not directly
absorb resources or create output. Examples:

 Taxes-Personal and company income taxes, VAT, indirect taxes, excise and stamp
duties.

 Subsidies ---- Including those given via price support schemes.

 Tariffs on imports and exports subsidies and taxes .

 Producer surplus - gains received by a supplier

 Credit transactions - loans received and repayment of Interest and principal

 EX– welfare(financial aid), social security, and subsides

Externalities (±) :A project may have a negative or positive impact on specific groups in
society without the project entity incurring a corresponding monetary cost or enjoying a
monetary benefit.For example, an irrigation project may lead to a reduced fish
catch.Once the financial and economic flows have been correctly identified, analysts
need to adjust the prices to reflect economic opportunity costs.

The main price adjustments include

 Using borderprices for all tradable goods and services and

 a shadow ex-change rate to convert foreign to domesticcurrency.

If non-tradables are a sizable part of project costs, their prices should be adjusted to
reflectopportunity costs to society. Labor is one of the most important non-tradables. It
is suggested thatanalysts use sensitivity analysis to determine whether the project's
NPV turns negative when using anupper boundary for the shadow price of labor, which
is usually the market price. If the NPV is positive,then you do not need further analysis.
Information about the sources of divergence between border andmarket prices and
between shadow and market exchange rates helps identify the groups that benefitfrom,
and pay for, the differences.

For transport, health, and education projects, analysts usually needto use indirect
measures of the value of these goods and services. The final price adjustments affect
non-tradables. In many cases, especially in health and educationprojects, volunteer

151
labor is an important component. To assess project costs and sustainability correctly,
such contributions need to be priced at their opportunity costs.

Example: enterprises will pay workers the market wages and not in real Birr (not
shadow ones) irrespective of what is believed to be their opportunity cost from the
economy’s viewpoint. Similarly, the enterprise will collect for its exports the equivalent
of local currency calculated at the official exchange rate, even when the foreign
currency is undervalued. Note that the estimation process should include the valuation
and inclusion of any un-priced outputsor inputs such as public goods or social
services.Stakeholders analysis/Income distribution/: Then the analyst needs to
identify gainers and losers, and undertake a risk analysis.

The sources of divergence between economic and financial prices and economic and
financial flows convey extremely useful information that enables analysts to address
three important issues:

By identifying the groups that enjoy the benefits and pay for the costs of the project, this
comparison shows the impact of the project on the main stakeholders and gives an
indication of its sustainability. In particular, because taxes and subsidies are usually
important sources of difference, this step essentially assesses the project's fiscal
impact.

1.3 Determining economic values

As indicated in our previous discussion, Markets are distorted for social, political,
historical, and economical reasons consequently the signals they give in the form of
prevailing prices are also distorted and do not reflect marginal productivities and
marginal utilities. Divergence between economic and market prices could be due to
market failure, government interventions, externalities, public goods and distributional
considerations. Hence serious distortions exist in the market for labor, capital and
foreign exchange and efforts are necessary to replace the signals from these markets
by more appropriate measures.
Economic pricing involves making adjustments to market prices to correct for
distortions and then the adjusted price should then reflect the true opportunity cost of
an input or people's willingness to pay for it.
Under this section you will be introduced about the Shadow pricing, traded and non-
152
traded commodities, border parity pricing, national parameters and standard conversion
factors. After studying this section you will be able to achieve the following objectives.
1.3.1 Adjustment for transfer payments
The fires step in adjusting financial prices to economic values is to estimate direct
transferpayment. Direct transfer payments are payments that represent only the
transfer of claims toreal resources from one person in the society to another, not
the use of real resources. The most common transfer payments are taxes, direct
subsidies, and credit transactions that include (normally) loan receipts, repayments
of principals, and interest payments. All these entries should be taken out before the
financial accounts are adjusted to reflect economic values.
1.3.2 Shadow pricing
Market prices represent shadow prices only under conditions of perfect competition,
which are almost invariably not fulfilled in developing shadow prices. Hence, there
is a need for developing shadow prices and measuring net economic benefits of
goods/services in terms of these prices to guide the allocation of resources.
The term shadow prices or accounting prices refers to a price that has been
calculated with a certain objectives in mind, such as maximizing economic growth,
improving the BOP, and enhancing employment opportunities consistent with the
existing development policies and resource endowment. The shadow price of
goods and services is thus a measure of its value to the economy as a whole in
terms of the above objectives. It is also a set of prices that are believed to reflect
better the opportunity costi.e. the value in their next best alternative use of different
goods and services. These prices are used instead of domestic market prices in
guiding the allocation of resources for the latter does not reflect the opportunity
cost and therefore using market prices would lead to resource misallocation. The
role of shadow prices is thus to guide efficient resource allocation to achieve
improved economic efficiency and it ends there.
Rationale: Market prices in developing countries are generally often unreliable of the
real worth of goods and services bought and sold in the market. Markets in most
countries andparticularly those of developing countries, often do not function in
such a way that the pricesand opportunity costs are the same. As a result,
operation of the market mechanism does not lead to optimal allocation of scarce

153
resources. A difference between market prices andopportunity cost occurs
particularly in labour markets because of statutory minimum wages, trade union
pressure, and imperfect information in markets for capital and foreign exchange.
Therefore, in order to arrive at the economic values of these inputs it is necessary
to adjust the prices to take into account of market imperfections1. This suggests
the need to developing efficiency shadow prices and measuring net economic
benefits of goods/services in terms of these prices to guide the allocation of
resources.
Efficiency or Economic Shadow prices
As it is discussed, market prices are inappropriate in project selection, the question
arises how the necessary accounting prices should be estimated. Thus the economic
analysis of projects requires that inputs and outputs be valued at their contribution to
the national economy, through efficiency or Shadow prices. From the national economic
point of view it is the alternative production foregone or the cost of alternative supplies
that should be used to value project inputs and outputs. An economic or shadow price
reflects the increase in welfare resulting from one more unit of an output or input being
available.
Definition of shadow (accounting) prices
Accounting or shadow prices are simply a set of prices that are believed to better reflect
the opportunity cost i.e. the cost in their best use of goods and services. It is the value
of Used in economic analysis for a cost or benefit in a project when the market price is
left to be a poor estimate of economic value.
Efficiency shadow prices are border prices determined by international trade. The basic
assumption here is that international market is less distorted than the domestic market
and thus taking international price is more realistic to value the true cost of goods and
services.
Shadow price estimates can be made at two levels:
 Economic analysis
 Social analysis
In economic analysis resource efficiency is considered. In social analysis growth and
income distribution objectives are pursued.

154
1.3.3 Traded and Non-Traded commodities
As we have discussed market prices are inappropriate in project selection and the
question that arises would be how the necessary accounting (shadow) prices should be
estimated. The valuation of goods and services depends on whether the good can be
traded in international market or whether it is consumed locally such as in a closed
economy.
Non-Traded Goods
The non-traded goods are goods that do not enter into the international trade because
of their nature or physical characteristics. So the non-traded inputs and outputs of a
project cannot be valued directly at border or world prices. When goods do not enter in
to trade by their very nature decomposing is a pre requisite to their valuation in terms of
would prices. For some non-traded goods no reference border prices are available.
Example: Teff. For other commodities the local supply price is below the CIF (Cost,
insurance and Freight) price of potential imports but above the FOB (Free on board price)
of potential exports. In both cases the non-traded inputs and outputs of the project
cannot be valued directly at border or world prices. So the valuation of non-traded
goods at world prices consists of a number of steps.
(a) Net out taxes from the domestic market price of the commodity
(b) The net of taxes price is decomposed in to its traded and non-traded cost elements.
For the traded components a border price is available by definition and they are valued
at this price. The non-traded items are further decomposed into traded and non traded
and the procedure continues until in successive rounds the original inputs or outputs is
developed in to traded components and labor.
Example: consider the production of electricity from coal. Major cost elements are coal,
transport of coal to its site; transmission costs wages and salaries, etc.If the out put of
a project is a non-traded good for which border prices are however, known and if its
domestic supply price is below CIF but above the FOB, a convenient approximation is to
value it at the average of the two.
Traded Goods
Traded goods are defined as goods and services whose use or production causes a
change in the country's net import or export position. Traded goods produced or used
by a project do not actually need to be imported or exported themselves, but must be
155
capable of being imported or exported.Traded goods are either exportable or importable
goods or Services. Exportable goods are those whose domestic cost of production is
below the FOB export price that local producers can earn for the good on the
international market.
1.3.4 Valuation of Traded and Non-traded commodities
1.3.4.1 Valuation of Tradable commodities
The economic benefits of producing tradable outputs and costs of using tradable inputs
are measured by the border price of these inputs and outputs. An importable border
price is its CIF import price - its price landed in the importing country before the effects
of any tariffs or quantitative restrictions have been added to its price. The landed cost
of an import on the dock or other entry point in the receiving country includes the cost
of international freight and insurance and often includes the cost of unloading on to the
dock. But this excludes any changes after the import touches the dock and excludes all
domestic tariffs and other taxes or fees. The CIF price represents the direct foreign
exchange cost of the input up to the port or the border.
Similarly an exportable good should be valued at a border price or FOB export price. The
FOB price is the price that would be earned by the exporter after paying any costs to get
the good to the border, but before any export subsidies or taxes were imposed. The
border price (FOB price) should be netted from handling, transportation and marketing
expenses to arrive at the project site place. The FOB border price is the actual foreign
exchange earned from exporting the export price minus any marketing margins and
transport costs to get the good from the project site to the border.
1.4 Border parity pricing
World prices are normally measured as border prices reflecting the value of a traded
good at the border or port of entry of a country. Border price is the unit price of a traded
good at a country's border (FOB for exports and CIF for imports.) However, values in
project financial statements will normally be at prices received by the project -ex -
factory or farm gate prices or paid by the project for inputs. To move from market to
shadow price analysis, therefore, shadow prices must in terms of prices to the project.
This means that for traded goods domestic margins, relating to transport and
distribution (including port handling) will have to be added to prices at the border to
obtain values at the project level.
156
The decomposition of these margins is referred to as border parity pricing. A parity
price or parity economic value is the price or value of a project input that is based on a
border price adjusted for expenses between border and the project boundary.
To assess the full economic values of a traded good in a world price system requires
both its foreign exchange worth at the border, plus the value at world price of the non-
traded activities of transportation and distribution required per unit of output. Thus for
goods that are traded directly by a project the border parity price for the project out put
is the FOB price minus the value of transport and distribution. These later costs must be
deducted since real resources are required before the good can be exported.
Similarly where a project imports an input its border parity price is the CIF price plus
transport and distribution costs. If the project does not actually import or export the
goods concerned but produces that save imports (import substitutes) and uses
domestic goods that could have been exported (exportable) or could have been
imported (importable) the adjustment is less straight for word.
1.5 National parameters and standard conversion factors
1.5.1 Conversion factors
As has been stated that all project inputs and out puts should be valued at the world
prices, which are the border prices. World prices are used to measure the opportunity
cost to the economy of goods and services, which can be bought and sold on the
international market. This means the world price reflect the terms on which it can buy
and sell on the world market. However, in practice there are significant number of
commodities for which there will be no direct world price to use as a measure of
economic value. (Example Teff) of non-traded goods.
Thus some world price equivalent figure need to be derived for these non traded goods.
To estimate the efficiency (accounting prices) for all other non-traded gods, (inputs and
outputs) we use conversion factors
A conversion factor is defined as the factor by which we multiply the actual price in the
domestic market of an input or out put to arrive at its accounting price when the latter
cannot be observed or estimated directly. The more then inputs and out puts are traded
the less will be the need to use conversion factors. The conversion factor is simply the
ration of the shadow price of the item to its market prices. A conversion factor is
estimated simply by taking the ratio of border prices (world prices) to domestic market
157
prices of the good.
National parameters:
There are some important parameters that have general applicability in the sense that
they are used in all projects. These parameters should take the same value in all
projects although they can change from time to time. In other words such parameters
are national in that they apply to all projects regardless of their sector, and they are
economic because they reflect the shadow price of the items concerned. A typical list of
national economic parameters covers conversion factors for:
 Unskilled and skilled labor
 Some of the main non-traded sectors
 Some aggregate conversion factors such as consumption conversion factor, a
standard average conversion factor, the discount rate, etc.
A project analyst can apply these parameters directly to the project under analysis. They
are called national parameters to distinguish them from the project specific shadow
prices. They are estimated by the central planners a dare taken as given by the project
analyst. How many parameters should be estimated depends upon the economic
conditions of the country and the degree of sophistication desired in project analysis.
However, a minimum of three or four national parameters should be estimated:
 The standard conversion factor
 The shadow wage rate
 The discount rate and
 The shadow exchange rate
1.5.2 The standard conversion factor
This is an all - inclusive conversion factor used in place of commodity - or sector
specific conversion factors, either because they can not be estimated accurately, or
because we believe that they can not be estimated accurately or because they do not
differ substantially from the standard conversion factor. It is a summary measure to
calculate accounting prices for non traded commodities.
In the case of Ethiopia the standard conversion factor is interpreted as a summary and
approximate quantification of the distorted markets (domestic) as compared to the
international market. It is therefore estimated as the ratio of the value of imports and

158
exports of a country at border prices (CIF and FOB) to their value at domestic prices.
The formula for computing the standard conversion factor is given as:
M X
ScF 
(M  Tm  Sm )  ( X  Sx _ Tx )

Where = M and X are total imports and exports respectively at world prices converted at
the official exchange rate.
= Tm and Tx are the total trade taxes on imports and exports respectively.
= Sm and Sx are total trade subsidies on imports and exports respectively.
All values should refer to the same year or to an average over the same period. The SCF
is a summary measure to calculate accounting prices for non traded goods. This is
achieved by multiplying the net of taxes domestic prices of one commodity by the SCF.
Thus every effort must be made to decompose the, non-traded goods in to traded and
non-traded elements and apply the SCF only to the latter. The rule for the non-traded
goods should be still decomposition and the SCF should be used only when this is
impossible, very difficult or is not worth the effort. The SCF is revised from time to time
by the central economic authorities and adopted by planning bodies.
To summarize, although in general it is recommended that a different accounting price
be estimated for different non-traded goods. It is useful to have available a standard
conversion factor that can be used for non-traded goods which remain after one or two
rounds of decomposition. For this purpose, the ratio of the value of border prices of all
exports and imports to their value at domestic prices might be used.
SCF / OER  1 / SER .

1.5.3 The Economic valuation of foreign Exchange:

As we have discussed in our previous Sections, border prices are used to value the
economic benefits and the cost of project's tradable inputs and outputs. In project
appraisal the foreign exchange earnings and costs are usually converted in to local
currency so that they can be included in the project's cash flow with its non-traded
inputs and outputs. The OER (official exchange rate) would be applied on the border
price of exported commodities, X (fob price) and to that of each of the imported inputs,
M (C.i.f) to value of them domestically. This is so because in very few countries in the
world there is little or no gov't intervention and few imperfections in the country's traded
159
goods and foreign exchange markets. However, there are many distortions in the
market for foreign exchange and traded goods.

There are many distortions in the market for foreign exchange and traded goods.
(a) The market for foreign exchange may be strictly controlled and it may only be
possible to purchase foreign exchange for permitted purposes. These controls may be
imposed because the fixed official exchange rate is over valued. Which results in the
demand for foreign exchange greatly exceeding supply
(b) A currency is over valued if the official exchange rate understates the amount of
domestic currency that residents of the country would be willing to pay for a unit of
foreign currency if they could freely spend it on duty free goods -goods sold at their
border prices. Trade distortions such as import tariffs and quotas; result in a country's
currency being over valued. After studying this unit you will achieve the following
objectives.
 Understand and explain the premium on foreign exchange
 Explain shadow exchange rate
 Describe foreign exchange premium and valuation of traded goods.
1. The Foreign Exchange Premium

In the official exchange rate, OER, expressed in terms of units of local currency needed
to buy one unit of foreign exchange is fixed below their equilibrium level it is said to be
over valued. This means that an unrealistically high value is placed on the local currency
in terms of how much foreign exchange can be bought with a unit of currency.
Countries that have an over valued exchange rate or to have a foreign exchange
premium (FEP). A FEP measures the extent to which the OER under states the true
amount of local currency that residents would be willing to pay for a unit of foreign
exchange, or its true opportunity cost to the economy. It is defined as the proportion by
which the OER overstates the real value of local currency or of non-traded goods and
services relative to traded goods and services. It is used to calculate the shadow
exchange rate and the standard conversion factor for economic analysis.
The FEP can be measured by the ratio of the value of total trade, imports plus exports,
values in domestic prices and there fore including the effect of tariffs and other
distortions, to the value of trade in border prices, minus one, as given below.
160
 M (1  t )  X (1  d  s ) 
FEP   x 100 percent
 M  x 

Where: t = tariffs, or tariff equivalents of non - tariff barriers, imposed on imports.

d = are the export tax equivalent on any restrains and taxes imposed on exports
s = are the export subsidy equivalent to any support given to encourage exports
M = is the value of imports in border prices, C. i.f
X = is the value of exports in border prices, fob.
The numerator measures the total amount in local currency that residents are actually
paying to consume imports (including tariffs and taxes) plus the amount they are
actually accepting for exports (excluding export taxes and including export subsidies). It
there fore measures the true values placed on traded goods produced and consumed in
the country.
The denominator shows the actual foreign exchange value of these traded goods. They
are measured at their border prices, converted in local currency at the OER. The ratio of
the domestic value to the border price value, there fore, shows the true value on traded
goods, relative to apparent economic values at the official exchange rate. FEP is usually
expressed as % (that is why we subtract 1 and multiply it by 100). The result show the
extra % that consumers are willing to pay over and above the OER if we were able to buy
currency freely and spent it on duty free goods.
If both traded and non-traded commodities are used or produced in a project, they need
to be valued in comparable prices before they can be used together in net cash flow of a
project.
2. The Shadow Exchange Rate

One way to correct for an over valued exchange rate in project appraisal is to use a
shadow exchange rate, rather than the official exchange rate to value all foreign
exchange earned and used by the project.
The SER is that rate of exchange which accurately reflects the consumption worth of an
extra dollar (or other convertible foreign currencies) in terms of one's own currency.
Thus the SER is the shadow price of foreign exchange and reflects the foreign exchange
premium. Thus one-way to adjust for the over valuation of local currency is to increase
the OER by the foreign exchange premium to obtain a shadow exchange rate. In order to
161
make it more clear, see the following example. Example: If consumers in an economy
would be willing to pay 20 percent more than the OER to obtain foreign goods, then the
foreign exchange premium is 20 percent and the OER would be increased by 20 percent
to obtain the SER. Thus if the OER were birr 10 = 1$US, then the SER would be birr 12 =
$ US1.
Thus the input which is traded a cross international borders and is found in the project
account it would be valued not at the OER but at the SER. This will make imports more
expensive and there by encourage the use of plentiful domestic resources rather than
use foreign exchange. A simple definition of a country's SER involves addition of the
percentage FEP to the OER, or more precisely, multiplication of the OER by one plus the
FEP divided by 100.
 FEP 
SER  OER   1
 100 

Example: If FEP is 100 percent and if the OER is 1 us dollar is equivalent to birr 10, then
the shadow exchange rate can be estimated by:
 100 
SER  Birr 10 / us $   1   birr 20 /1 us $
 100 

The Shadow exchange rate would therefore, be birr 20 per 1US $. Thus foreign
exchange infract has twice the value indicated by the official exchange rate.
The SER can also be derived from the definition of the FEP.
 Value of trade in domestic prices 
SER  OER  
 Value of trade in border prices 

M (1  t )  x (1  d  s) 
 OER  
 M  x 

Where: x, M, t, d, and S are defined as before the value of export (FOB), value of import
(CIF), tariffs imposed on imports, and export subsidy.
3. Foreign Exchange premium and valuation of traded goods

There are two main approaches for correcting for any premium placed on foreign
exchange when valuing traded and non-traded goods in project appraisal. The first is

162
the approach proposed in the Guidelines for project Evaluation (UNIDO, 1972) and the
second approach is that developed by Little and Mirrlees in project Appraisal (The
border price (BP) Approach.)
The UNIDO Guide lines or the Domestic price Approach.
The most simple and widely used formula in estimation of shadow exchange rate (SER)
is the one developed by UNID 1972. It attempts to measure, in local domestic prices, the
increase in welfare in an economy that will be generated from one additional unit of
foreign exchange.
The UNIDO SER formula is the weighted average of the ratio of the domestic prices to
border prices (C.i.f or fob) of all goods traded by the country, where the weights reflect
how the next dollar of foreign export (FX) would be spent.
n  Pad  h  Pbd 
SER   fa     Xb   x OER
 a 1  Pacif  b 1  Pbfob 

Where:
fa = is the fractional increase in each of the country's n imports as a result of a one local
currency (birr) increases in the availability of foreign exchange
Xb = is the fractional fall in each of a country's h exports in response to a 1 birr increase
in the availability of foreign exchange
Pad and Pbd = are the domestic market clearing prices of ath importable goods and the
th
b exportable good, respectively.
Pacif = is the C.i.f price of ath importable good, measured in birr, converted at the official
exchange rate.
Note: the Pad diverges from Pacif because of tariffs and non-tariff prices; while the Pbd
diverges from Pb fob because of export taxes and subsidies.
Example: Assume that 1 birr of addition FE becomes available as a result of the project.
Of this 85% is spent on increase imports of wheat (M) and 15% on purchasing rice,
which would other wise have been exported (X). The C.i.f price of M at the OER is birr
3/kg and its market clearing domestic price is birr 4/kg due to tariff and non-tariff
barriers with a tariff equivalent of 50%. The fob price of exportable price is birr 3kg while
its domestic market-clearing price is birr 2/kg, due to an export tax of 33%. The SER in
this simple two-good economy would be: SER=0.85x (4.5/3) +0.15x(2/3)=1.374xOER
163
Since the OER in this economy is birr. 10/$ US1,
SER  birr 13 . 74 / $ US 1 .

The UNIDO approach values all traded and non-traded goods and services in terms of
domestic price equivalent. Domestic prices are used as the numeraire or the common
unit of account in terms of which all project inputs and outputs are valued. A project's
non-traded inputs and outputs are simply valued in domestic prices. Since they are, thus
valued at comparable prices it will be legitimates to add them in the projects cash flow
for this reason this approach called the domestic price approach.

The project's traded goods inputs are firstly valued in their FOB and CIF border price.
They are then converted from foreign currency to local currency using a shadow
exchange rate, SER, rather than the official exchange rate, OER. This is done to better
reflect the true economic value of foreign exchange to the economy.
The domestic price approach corrects for the FEP by inflating the border price values of
traded goods, using the economy's estimated SER, until these values correctly reflect
the goods relative worth compared with the domestic prices of non-traded goods.
In sum this approach values
Traded goods Non-traded goods
@ Border price x SER @ Domestic prices
→ Domestic price Equivalent
Numeraire: Domestic prices or Domestic consumption
Note: In a situation where the local currency is over valued and the foreign exchange
premium is positive, the ratio of the SER to OER will be greater than one when both are
expressed in terms of local currency per dollar or foreign exchange. Use of a shadow
exchange rate to convert the border prices of traded goods in to local prices will have
the effect of inflating these border prices until they equal the amount that people are
willing to pay, or receive, for traded goods. As these traded goods will now be values in
domestic price equivalent they will be directly comparable with the project's non-traded
inputs and out puts valued in domestic prices.
Practical Example: Valuation at domestic price
(a) Valuation of Imported inputs
In the Table below it has been estimated the country has a foreign exchange premium

164
of 30% and the shadow exchange rate is there fore (1+0.30) x OER. All tariffs and taxes
are deducted from the domestic retail price and their tradable (FX) component is
inflated by the SE to obtain the domestic price equivalent of the C.i.f import price. The
economic cost of domestic transport and handling is then added.

Valuation of imported inputs using the domestic price approach.

Financial cost Economic cost
(in million birr)
CIF import price @ OER 250 -
(@SER = 1.3x OER) - 325
Import tariff (40%) 100 0
Handling & distribution 50 20
Internal transport 50 50
Total 450 395
Ratio of Economic value: financial value = 395/450 = 0.88
60% of these costs represent rents earned from privileged access to foreign exchange,
and therefore not included in the economic costs of handling and distribution.
(b) Valuation of exported output
The table below shows valuation of a project's exported out put, using the domestic
price (DP) approach. The country has 30% of FEP. The Foreign export (FX) earnings are
inflated by the SER and all export subsidies are deducted from the fob export price to
obtain the domestic price equivalent of the border price.
Valuation of exported out put using the domestic price approach.
Financial value Economic value
FOB out putvalue @ OER 1200 -
(@SER = 1.3x OER) 1560
Export tax (10%) -120 0
Transport to the port including -40 -30
25% fuel tax)
Total 1040 1530

Ratio of economic value: financial value = 1530/1040 = 1.47

The market price of transport includes a 50% fuel tax. Since fuel equals has of total
transport costs, its economic value = 40 - (40x 0.5 x 0.5) = 30

165
 1.5.4 valuation of non-traded goods
The valuation of the non-tradable goods is done straight forward since they are given at
domestic price. If this non -tradable goods supply can increase, its economic value can
be measured by its domestic market supply price (after adjustment for market
imperfection such as taxes, subsidy, price fixing etc has been made.) If the project uses
a non-tradable goods (such as electricity) diverted from exiting consumers, then it
should be valued at the price that people were willing to pay for it, its demand price.
The Little - Mirrlees (LM) Approach or The Border price (BP) Approach
Like that of UNIDO, it also values trade goods at their border prices. However, these
border prices are converted into local currency at the official exchange rate (OER),
rather than SER. In this approach the projects traded good inputs and outputs are
effectively kept in their border price. However if there is a FEP in the country, the price of
non-tradable goods will have risen to match the tariff inclusive price of tradable. The
price of non - tradable goods therefore over states the good's true value to consumers,
relative to the border price of traded goods.
The border price (LM) approach therefore re-values these non-tradable goods in border
price equivalents using commodity specific conversion factors. A conversion factor is
the ratio of the border price equivalent of non-tradable goods to its domestic price.
Multiplying the domestic price value of non-traded good by its conversion factor has the
effect of converting the goods domestic price into its border price equivalent. Both non-
traded and traded goods are then valued in the same numeraire, border price, so it is
legitimate to add them in the computation of the projects cash flow. This is the reason
why it can be called the border price approach.
The border price approach values
Traded goods Non-traded goods
@ border price X OER @ domestic price i X CFi
→ border price equivalent
Numeraire: border prices
border price quivalent i
CFi: = conversion factor of good i =
domestic price i

Simply written it can be depicted as

NB  OER ( x)  OER ( M )  D or NB  OER (x  M )  D

166
Where  a conversion factor defined as OER / SER.
Example:
Valuation of imported inputs using the border price approach
Financial value Economic value
CIF import price @ OER 250 250
Import tariff (40%) 100 0
Internal transport 50 40
Handling and distribution 50 14
Total 450 304
Ratio of economic value : financial value = 304/450 = 0.68
The conversion factor for transport, which puts the domestic price of transport into its
border price = 0.8, hence the transport's economic value = 50 x 0.8 = 40
The conversion factor for handling = 0.7. Hence economic value = (financial value x 0.4)
x Cfi = 20 x 0.7 = 14.
60% of items represent rents earned from privileged access to foreignexchange.
Valuation of exports outputs using the border price approach
Financial value Economic value
FOB out put price @ OER 1200 1200
Export tax (10%) -120 0
Transport -40 -24
total 1040 1176
Ratio of economic value: financial value = (176/1040) = 1.13
The 50% fuel tax is deducted (fuel - half transport tax), and the conversion factor (CF) =
0.8, hence the transport's economic value N [ 40. (40 x 0.5 x 0.5) ] x 0.8 = 24
Finally the non-traded goods, which are given in domestic price will be converted using
the commodity specific conversion factor (CFi).
 There are two types of numeraire, border price and domestic price
 Computed border parity prices, we used the OER to convert border prices and then
applied conversion factors on non-traded goods
 There are two main approaches for correcting for any premium placed on foreign
exchange when valued traded and non-traded goods in project appraisal.
 the UNIDO approach or the domestic price approach

167
 The Little -Mirrlee (LM) or the border price (BP) approach
Comparing the two Approaches
Suppose a project, an oil refinery, produced petrol for export, worth X in border prices
and uses imported crude oil, worth M in border prices, and a non-traded input,
construction services, worth N in domestic prices. The out put of the Non-tradable input
can be expanded to meet the projects requirements.
(a) Using the domestic price (DP) approach, we can value it as
B1 = [(SER) x X) - [(SER) x M) - aN ...................(1)
Where a is the factor that corrects for domestic distortions and converts the market
price of construction services N, 10 its true economic value measured in domestic
prices. It corrects for taxes, subsidies etc.
(b) Using the border price (LM) approach we will have:
B2 = ((OER x X ) - ((OER) x M) - CN ....................(2)
Where:
C is the supply price conversion factor that converts the domestic supply price of
construction, N, into border price equivalent.
The two approaches lead to an identical result if:
C = ax (OER/SER) ................................................(3)
Substituting C in the Second equation above gives,
B2 = (OER) x X - (OER) x M - (OER/SER) x N ........................... (4)
Multiplying both sides of the above equation, (4), by (SER/OER) gives,
SER  SER   SER 
B2 x B2 x  ( OER ) x  x X  ( OER ) x   x M  aN
OER  OER   OER 
 ( SER ) x X  ( SER ) x M a N

=B1
This implies that there is a constant relationship between the NB of a project measured
by the two approaches la positive NPV in one implies a positive NPV in the other
approach. The ratio OER/SER in equation (3) is called the standard conversion factor
(SCF) and is an average conversion factor for the whole economy. It is different from C,
which is a commodity specific conversion factor for the non-traded goods.

168
 1.5.5 The valuation of primary factors of production: (Land, Labor, and
Natural Resources)
As you know in other economic courses, the most important factors of production are
land, labor, capital and entrepreneurship. In Economic Analysis of projects, valuation of
primary factors of production is quite essential because it is difficult to accept or reject
the project without having the value of projects.
1. Distortions in the Labor Market
For most types of labor services it is not possible to directly establish a border price
merely because most people cannot travel freely between countries to sell their labor.
Labor services are there fore, a form of non-traded primary factor and can be valued in
mush the same way as non-traded goods and services. However, labor cannot be
treated just like other factor of production and should be treated uniquely.
Distortions in the labor market for unskilled and skilled labor may result in the wages of
such labor exceeding their marginal revenue product, valued in economic prices.
Examples of labor market distortions are minimum wage legislation. Centralized wage
fixing and restrictive union practices. These distortions are usually more common in
urban areas because government control and union activity are stronger there.
Nevertheless, it is believed that distortions exist only in the market for unskilled labor.
The market for skilled labor is taken to be relatively competitive and there may not be
the need for special shadow salaries for skilled personnel. It is assumed that the market
for skilled labor reflect marginal productivities subject to the overall distortions of the
economy as expressed by the standard conversion factor (SCF).
2. The valuation of unskilled labor
The total number of unskilled workers available in an economy cannot normally be
expanded in response to market demand unless there is substantial immigration
program in the country concerned. Labor service can there fore be treated as a non-
traded primary factor, which is in elastic supply.
Since unskilled labor is generally in fixed supply when a project uses labor it will have to
draw it away from other employment some where in the economy. This labor may
actually come from another sector such as agriculture. If anon-traded factor is removed
away from other users, its economic cost is what they were willing to pay for it.
If labor markets were generally efficient and there is no government intervention in the

169
form of minimum wages, wage fixing, hiring constraints or income taxes, the market
wage rate paid for this labor should reflect the contribution the marginal worker makes
to the total revenue of the employer. The market wage rate received by the labor in its
previous employment will therefore, reflect its forgone out put. In these circumstances
the market wage could be used directly to determine the economic cost of labor.
However, in market distortions it would be necessary to determine the true cost of the
project labor requirements to the economy by calculating the shadow wage rate (SWR)
or the marginal social cost of labor. The basis for the derivation of the SWR is the
forgone output or labor's marginal contribution to the revenue earned in the occupation
from which it has been drawn.
Thus even when the project worker is recruited among the urban unemployed as long as
he is replaced by another unemployed coming from the rural area, it is the opportunity
cost of the latter that we should take into account in estimating the shadow wage rate.
As it has been discussed there are two approaches to value the non-traded inputs. The
UNIDO approach or the LM approach. If we use the border prices as the unit of account
and thus all out put forgone must be valued at border prices, then the general
expression for the shadow wage rage (SWR) is given as:
SWR  a : M : .CF :

Where: M: is the output foregone in alternative employment at domestic market prices.

CF: is the conversion factor required to convert this out put to world/ border prices
ai is the proportion of new worker of type i coming from activity i.
Thus the conversion factor for labor i is given as:
CFI - SWR/MWR
Where MWR is the market wage rate and CFL is the labor conversion factor.
The above approach does not mean that international wage rates are used instead of
domestic ones, but that the physical units of out put forgone are valued at border prices
rather than domestic prices.
If the domestic price system (UNIDO approach) is used then the treatment of labor is
directly comparable in a domestic and a border price system. Again labor's shadow
wage is the output forgone, but in a domestic system this measured in domestic rather
than border price units. The general expression of the shadow wage rate will be relevant

170
again except now there will be a new set of CFs for the different commodities foregone
so that.

DPSWR  aim DPCFi

Where: DPSWR is the SWR in domestic prices and DPCF is the domestic price
conversion factor for good i.
3. The Valuation of Skilled Labor:
The economic cots of skilled labor are in principle estimated in exactly the same way
for unskilled labor. The significance difference though, is that there is more general
agreement that skilled labor’s wage reflect its marginal product reasonably accurately.
Two reasons are often presented to support this argument:
1. Skilled labor is more specific, often being highly mobile in nature and wages tend to
be competitive and full employment is the rule.
2. The supply of skilled labor is increasingly equated to its present and future demand
by the Use of manpower planning techniques, which has the virtue of missing
discrepancies between supply and demand and hence relieving the price mechanism of
part of the burden of adjustment.
4. The valuation of Land

The term land covers not merely land parcels but other material resources such as
forests, fishery reserves, mineral deposits, etc. Thus it is important to examine
economic valuation of land. In principle, the capital value of land is the discounted value
of the stream of future earnings which it can command net of the cost of purchased
inputs and labor. I.e.,, it is the capitalized rental element. Where there is competitive
land market prices would equal the expected future gain from the purchase or rental of
an additional unit of land. But it is not obvious that existing land markets are sufficiently
competitive for price to be an adequate guide to productivity.
Example: Where land for a factory site was previously unused its direct opportunity cost
will be zero, since no out put would be cost by building the factory on the land, and only
land clearing costs can be properly attributed to the project. If an agricultural land is to
be used, its economic cost will be the sum of the discounted agricultural out put value
cost over the life of the project, net of the cost of other inputs, valued either in border
prices or in domestic prices.

171
 5. The Shadow price of Natural Resources

If the natural resources (mineral deposits, oil, natural gas deposit, etc.) Use in the
project are traded they should be valued at their FOB or CIF prices, depending on
whether they impact on exports or imports at the margin.
Example: if imported mineral is used it should be valued at CIF border price. If exported
mineral is used it should be valued at the FOB border price.
If the project uses a non traded natural resource input whoseout put can be expanded
this input should be valued at its supply price, its marginal cost of production. Its supply
price will be equal to the economic valued of the resource that is used to produce it. If
the project uses a non-traded natural resource that is in relatively fixed supply, it should
be valued at its demand price. If natural resource required by the project is in short
supply it is likely to earn a scarcity rent.

3.6Social cost benefit analysis

In essence, project analysis assesses the benefits and costs of a project and
reduces them to a common denominator. If benefits exceed costs both expressed in
terms of this common denominator-the project is acceptable: if not, the project
should be rejected.
Economic analysis of projects is similar inform to financial analysis in that both
assess the profit of an investment. The concept of financial profit, however, is not
the same as the social profit of economic analysis.
The purpose of Social Cost-Benefit Analysis
When under taking financial and economic project appraisal it is implicitly assumed
that income distribution issues are beyond the concern of the project analyst or that
the distribution of income in the country is considered appropriate. A financial
objective is narrow one for a public agency to pursue and for public decisions. But in
most countries governments are not only interested in increasing efficiency but also
in promoting greater equity.
When one project is chosen rather than another the choice has consequences for
employment, output, consumption, savings, foreign exchange earnings, income
distribution and other things of relevance to national objectives. The purpose of
social cost-benefit analysis is to see whether these consequences taken together

172
are desirable in the light of the objectives of national planning. Therefore, a social
appraisal of projects goes beyond economic and financial appraisal to determine
which project will increase welfare once distributional impact is considered. The
project analysts will not be only concerned to determine the level of project's
benefits and costs but also receives the benefits and pays the costs. In a situation
where a project is only marginal from the point of view of an economic analysis but
has strong positive distributional benefits, the analyst may consider a social analysis
in addition to the traditional economic analysis.
In an economic analysis of a project it is implicitly assumed that a dollar received by
any individual will increase the community's welfare by the same amount as a dollar
received by any other individual. But an extra dollar given to a very poar person will
usually increase the person's welfare by much more than would a dollar given to a
rich person. A rationale in welfare economic for the social analysis of projects is
there fore, quite strong, the marginal utility of income of a person who receives a low
income is expected to be greater than the marginal utility of income of the same
person if he or she receives a high income. An economic analysis of projects A & B
would not capture those differences and would merely indicate that both had the
same positive impact on community welfare.
Difference between financial calculation and Social cost-benefit Analysis:
Financial profitability is measured in terms of the difference between the value of
earnings and costs in a certain period. Social cost-benefit analysis must go deeper
and ask what is the meaning of profit.
1. The price offered in the market is not a good guide to Social welfare for it includes
the influence of income distribution on the prices offered. One of the simpler means
of income redistribution may infact be project Selection. The choice may be between
project A to be located in a poor region or project B to be located in a rich area or
between project X which uses a large amount of poor, unskilled labor which might
other wise be un employed and project Y which uses factors of production supplied
by rich people.
2. A project may have influences that work out side the market rather than through it.
These effects are called "externalities " externalities are relevant for social choice
and provide a sufficient argument for rejecting commercial profitability as a guide to
173
public policy. Externalities may arise in the process of production, in the process of
consumption, and in the process of Sales and distributions.
3. Even in the absence of externalities and consideration of income distribution
commercial profitability may be misleading because of consumer's surplus.
3.7Cost-effectiveness

Thus far we have focused on cost-benefit analysis. This technique is appropriate for
projects with benefits and costs that are measurable in monetary terms. A vast
class of projects generates benefits that are not easily measurable in monetary
terms. If the project measures its benefits in some non-monetary unit, the NPV
criterion for deciding whether to implement it cannot be used.
In such cases, economic analysis can still be a great help in project design and
selection. We use it to help select among programs that try to achieve a given result,
such as choosing among several methods to improve mathematical skills.
Economic analysis is also useful to select among methods that have multiple
outcomes. For example, three methods might be available for raising reading speed,
comprehension, and word knowledge. Each method may have a different impact on
each of the three dimensions and on cost. Economic analysis enables us to
compare the costs of various options with their expected benefits as a basis for
making choices.
Two main techniques exist for comparing projects with benefits that are not readily
measurable in monetary terms: cost-effectiveness and weighted cost-effectiveness.
In all cases we measure costs as shown in the previous sections. The main
difference between the approaches is in the measurement of benefits. If the benefits
are measured in some single non-monetary units, such as number of vaccines
delivered, the analysis is called cost-effectiveness. If the benefits consist of
improvements in several dimensions, for example, morbidity and mortality, then the
several dimensions of the benefits need to be weighted and reduced to a single
measure. This analysis is known as weighted cost-effectiveness.
The choice of technique depends on the nature of the task, the time constraints, and
the information available. We would use cost-effectiveness for projects with a single
goal not measurable in monetary terms, for example, to provide education to a given

174
numberof children. When the projects or interventions aim to achieve multiple goals
not measurable in monetary terms, we use weighted cost-effectiveness; for example,
several interventions may exist that simultaneously increase reading speed,
comprehension, and vocabulary, but that are not equally effective in achieving each
of the goals. A comparison of methods to achieve these aims requires reducing the
three goals to a single measure, for which we need some weighting scheme.
All evaluation techniques share some common steps. The analyst must identify the
problem, consider the alternatives, select the appropriate type of analysis, and
decide on the most appropriate course of action. This topic provides the tools for
identifying the costs and benefits and assessing whether the benefits are worth the
costs.
3.7.1 Cost-effectiveness Analysis
Cost effectiveness analysis is a technique closely related to cost benefit analysis .it
differs in that it asks a different question, namely given a particular objective, which
is the least cost way of achieving it? It aids choice between options but cannot
answer the question whether or not any of the options are worth doing. It is utilized
when there are difficulties in associating monetary values with the outcomes of
projects but where the outcomes can be quantified along some non-monetary
dimension.
In cost-effectiveness analysis, we measure the benefits in non-monetary units, such
as test scores, number of students enrolled, or number of children immunized. As an
example, suppose we want to evaluate the cost effectiveness of four options to
raise mathematics skills (Levien 1983):
o Small remedial groups with a special instructor
o A self-instructional program supported with specially designed materials
o Computer-assisted instruction
o A program involving peer tutoring
We first estimate the effect of each intervention on mathematics skills as measured by,
say, test scores, while controlling for initial levels of learning and personal
characteristics. Suppose we find that students taught in small groups attain scores of
20 points, those undergoing the self-instructional program score 4 points, those with
computer-assisted instruction score 15 points, and those in the peer-tutored group
175
score 10 points (table 3.9). These results show that small group instruction is the most
effective intervention.
Now consider cost-effectiveness. Suppose that the cost per student is US$300 for
small group instruction, US$100 for the self-instructional program, US$150 for
computer-assisted instruction, and US$50 for peer tutoring. The most cost-effective
intervention turns out to be peer tutoring; it attains one-half the gain of small group
instruction at only one-sixth the cost for a cost-effectiveness ration of only 5 (see
table 3.9). Cost-effectiveness analysis can also be used to compare the efficiency of
investment in different school inputs.
Table 3.9 Hypothetical cost-effectiveness ratios for interventions to improve
mathematics skills

Intervention Size of effect Cost per Cost

on test scores student (US$) effectiveness
ratio
Small group instruction 20 300 15
Self-instructional materials 4 100 25
Computer-assisted instruction 15 150 10
Peer tutoring 10 50 5
Source: Levin (1983)
Cost-effectiveness ratios must always be used with caution. In the above example,
peer tutoring is the most cost-effective intervention. If we have several cost-
effectiveness (CE) ratios and either the numerator or the denominator have exactly
the same value in all cases, CE ratio can be used safely for decision-making. CE
ratios would be safe to use if the benefits had differed, but the cost per student had
been the same for each intervention. If, however, both the measure of benefits – test
scores in this case – and thecosts per student vary among interventions, the analyst
should use CE ratios with caution. In the example above computer assisted
instruction produces a gain of five points over peer tutoring at an additional cost of
US$100, or US$20 per point. To choose peer tutoring over computer-assisted
instruction solely on the basis of CE ratios would be tantamount to saying that the
marginal gain in test scores is not worth the marginal expense. When using CE
ratios, we advise analysts to ask the following three questions:
 Can I increase the intensity of an intervention and improve the results?
 Can I combine interventions and improve the results?

176
  Is the intervention’s marginal gain worth the extra cost?

Cost-effectiveness in health
We can use cost-effectiveness in evaluating interventions that aim to improve the
health of a population. Suppose that we want to design a program of immunization
that would provide the maximum improvement in health for allocated program funds.
The package could include only DPT (a combination of diphtheria, pertussis, and
tetanus vaccines) for the child and T (tetanus toxoid) for the mother, or it could also
include BCG (Bacille Calmette Guerin, used to prevent tuberculosis) for the child. We
would want to examine the economic advisability of adopting a DPTT program, a
BCG program, or a combined DPTT plus BCG program rather than continuing with
the existing low level of immunization and treatment of morbidity for diphtheria,
petrtussis, and tetanus. Having mounted a DPTT program, suppose we want to
examine the advisability of adding a BCG program and vice versa.
Table 3.10 summarizes the incremental costs and benefits of adding an expanded
program of immunization to the existing program of health services. We measure
the benefits of the project in terms of the deaths prevented, as calculated from a
simple epidemiological model. We base this model on the number of immunizations,
the efficacy of the vaccines, and the incidence and case fatality rates of the
diseases involved. The most effective alternative is a complete immunization
program. A DPT only immunization program, however, is just as cost-effective. If the
budget constraint were US$115million, the most cost-effective feasible alternative
would be a program of DPT immunization.
This example starkly illustrates the limitations of CE ratios. In line 1, DPT only is just
as effective as line 3, a total immunization program. The cost per life saved for
either program is about US$480. Adding BCG to an existing program of DPTT,
however, saves an additional 29,500 lives at a cost of US$14 million, or US$475
dollars per life. Forgoing adding the BCG program to DPT on the grounds of CE
ratios alone would be tantamount to saying that each additional life saved is not
worth US$475.
Table 3.10 Cost-benefit comparison of immunization alternatives
Alternative Cost-benefit
Benefits Costs
(death prevented) (US$ millions) ratio
177
 DPTT only 231,900 111 478.7
BCG only 29,500 61 2,067.8
DPTT+BCG 261,400 125 478.1
Existing BCG,DPTT added 231,900 64 276.0
Existing DPTT,BCG added 29,500 14 474.6
Source: Authors
Assessing Unit Costs
We use unit costs for comparing the intervention’s efficacy within and across
countries. In education, for example, analysts often wish to know the average cost
per student of a particular intervention. Calculating the unit costs of a mature
intervention that has reached a steady state is the simplest of problems, as all the
capital costs have already been incurred. The recurrent costs and the number of
students enrolled are fairly stable.
Assessing unit costs for a new intervention is more difficult. Capital costs are
typically higher in the initial years, and enrollment and graduates are typically higher
once the project is working at full capacity. Thus, comparing costs and benefits that
occur at different points in time is necessary. The tools of economic analysis are
helpful in these instances as well. Given the cost and benefit profile of the project,
the analysis can discount the benefit and costs flows and compare them at a single
point in time.
Consider Higher and Technical Education Project. One of the purposes of this
project was to increase the number of graduates coming out of the University of the
country and the three polytechnic schools. The investment costs, which would be
distributed over five years, amounted to Birr 343 million (present value discounted at
12 percent). The recurrent costs would be proportional to the number of students
and would rise from about Birr 4 million in the initial year to about birr 21 million
once full capacity had been reached. The discounted value of the recurrent costs
over the life of the project was assessed at Birr 143 million. Enrollment, on the other
hand, would rise slowly from 161 students in the initial years, to about 3700 at full
capacity. To assess the cost per student, the number of students enrolled through
out the life of the project was discounted at 12 percent. The discounted number of
students was calculated at 13,575 students and the cost per enrolled student at
US$2048 at the then prevailing market exchange rate. Similar calculations show the

178
cost per graduate at about US$8700.
Analysts could use the same methodology to assess the unit costs of interventions
in health or in any project where the output is not easily measured in monetary terms.
For the moment, suffice it to say that by using this procedure, analysts are
discounting the project’s benefits. The number of students enrolled is a proxy for
these benefits. In this sense, the procedure is, in principle, the same as for projects
with benefits measurable in monetary terms.
3.7.2 Weighted Cost-Effectiveness

Sometimes project evaluation requires joint consideration of multiple outcomes, for

example, test scores in two subjects, and perhaps also their distribution across
population groups. In such situations, the analyst must first assess the importance
of each outcome with respect to single goal, usually a subjective judgment derived
from one or many sources, including expert opinion, policymakers’ preferences, and
community views. These subjective judgments are then translated into weights.
Once the weights are estimated, the next step is to multiply each of the outcomes by
the weights to obtain asingle composite measure. The final step is to divide the
composite measure by the cost of the options being considered. The results are
called weighted cost-effectiveness ratios.
Application in Education
Suppose that employing better-qualified teachers raises mathematics scores more
than language scores. To evaluate the two options for improving student learning,
the analyst must compare the effect of each option on mathematics and language
performance. The analyst could apply equal weights to the gains in test scores, but
if mathematics is judged to be more important than language, policy makers may
prefer to weight scores differently to reflect the relative importance of the two
subjects.
Owing to the many dimensions of learning, the need for weighting may arise even
when only one subject is involved. Consider the data in table 3.11 which show the
effects of two improvement strategies for three dimensions of reading skills, as well
as the weights assigned by experts to these skills on a scale of 0-10 points.
Assigning the weights is the trickiest part of the exercise; the rest of the calculation
is mechanical. Dividing the weighted scores by the cost of the corresponding
179
intervention gives the weighted cost-effectiveness ratio for comparing the
interventions. At a cost of US$95 per pupil for intervention A and US$105 per pupil
for intervention B, the option with the more favorable ratio is the latter.
Table 3.11 Weighting the outcomes of two interventions to improve reading skills
Category Weights Intervention Intervention
assigned by Aa Bb
expert opinion
Reading speed 7 75 60
Reading comprehension 9 40 65
Word knowledge 6 55 65
b
Weighted test score n.a 1215 1395
Cost per pupil n.a 95 105
Weighted cost-effectiveness
ratio n.a 12.8 13.3
n.a. Not applicable Source: Adapted from Levin (1983)
a. the scores on each dimension of outcome are measured as percentile ranking
b. The weighted score is calculated by multiplying the score for reading speed,
reading comprehension, and word knowledge by the corresponding weight and
summing up the result. The weighted score of 1215 for intervention A equals
(7x75+9x40+6x55).
Note that this procedure becomes meaningful only when the analyst scores
outcomes on a comparable scale. We could not compare, say, reading speed in
words per minute with reading comprehension in percentage of material understood.
The reason is that the composite score would then depend on the scale used to
measure the individual scores. The metric used must be the same for all dimensions
being compared. One procedure is to express all the scores in terms of percentile
rank, as in the earlier example. Applying the appropriate weights to the scores then
provides the desired composite score.
Application in health
Weighted cost-effectiveness is also useful for assessing health projects. Going back
to the immunization example considered before, the immunization interventions
reduce morbidity as well as mortality. A given intervention might have different
impacts on the reduction of these two indicators. To choose among several
interventions would require weighting morbidity and mortality to produce a single
measure of benefits. It has become increasingly common to measure and aggregate

180
reduction in morbidity and premature mortality in terms of years of life gained.
Table 3.12 Benefits from interventions: years of life gained from immunization
program
Category Mortality Morbidity Total Gain from Gain from
DPT only BCG only
Benefits (years) 56,000 16,992,000 17,048,00 15,127,000 1,921,000
Costs (US$ millions) n.a n.a 125 111 61
Cost-effectiveness n.a n.a 7.3 7.3 31.8
ratios
n.a Not applicable Source: Levin (1983)
Table 3.12 shows the costs and benefits of three interventions with the benefits
calculated in terms of health years of life gained, which are calculated as the sum of
the difference between the expected duration of life with and without the
intervention plus the expected number of years of morbidity avoided as a result of
the intervention. The analyst calculates the years of life gained from reductions in
mortality and morbidity by using thesame epidemiological model previously applied
to calculate deaths prevented by adding the computation of cases, information on
the average duration of morbidity, and years of life lost based on a life table.
Comparing option with subjective outcomes
Sometimes no quantitative data exist that relate interventions to outcomes.
Suppose that we want to assess two options to improve performance in
mathematical and reading, but have no data on test scores. The evaluator could first
ask experts to assess the probability that test scores in the two subjects will rise by
a given amount, say by one grade level, under the interventions being considered,
and then weighting these probabilities according to the benefit of improving test
scores in the two subjects. To elaborate, suppose informed experts judge the
probability of raising mathematics scores to be 0.5 with strategy A and 0.3 with
strategy B. Experts also judge the probability of raising reading scores to be 0.5 with
strategy A and 0.8 with strategy B. The information is insufficient to choose between
the strategies, however, because neither dominates for both subjects.
The weighted cost-effectiveness approach overcomes this difficulty by asking
policymakers or other relevant audiences to assign weights to the gain in test scores.
Suppose they assign a weight of 9 on a scale from 0-10 to a gain of one grade level
in mathematics and a weight of 6 to gain of one grade level in reading. The score for
strategy A would then be 7.5 (0.5x6+0.5x9), and the score of strategy B would be 9.0
181
(0.3x6+0.8x9). If strategy A costs US$375 and strategy A costs US$375 and strategy
B costs US$400, then the cost-effectiveness ratio would be US$50 for strategy A and
US$44 for strategy B. In this case, B could be the preferred strategy, because it is the
most cost effective and generates the highest benefits.
Some important caveats
When quantitative data on the relationship between project interventions and their
outcomes are available, and when only a single dimension of outcomes matters,
cost-effectiveness analysis offers a systematic tool for comparison. The method
does not incorporate subjective judgments. When such judgments enter into
measuring project outcomes, the method is called weighted cost effectiveness
analysis. The main advantage of weighted cost-effectiveness analysis is that we use
it to compare a wide range of project alternatives without requiring actual data.
The reliance on subjective data gives rise to important shortcomings in weighted
cost-effectiveness analysis. These shortcomings related to two questions: Who
should rank the benefits of the options being considered? How should the ranking of
each person or group be combined to obtain an overall ranking?
Choosing the right respondents is critical. An obvious group to consult comprises
people who will be affected by the interventions. However, other relevant groups
include experts with specific knowledge about the interventions and government
officials responsible for implementing the options and managing the public
resources involved. Given that the choice of respondents is itself a subjective
decision, different evaluators working on the same problem almost invariably arrive
at different conclusion using weighted cost-effectiveness analysis. The method also
does not produce consistent comparisons from project to project.
Analysts must be careful when consolidating individual rankings. Preference scales
indicate ordinal, rather than cardinal, interpretations. One outcome may assign a
score of eight as superior to one assigned a score of four, but this does not
necessarily mean that the first outcome is twice as preferable. Another problem is
that the same score may not mean the same thing to different individuals. Finally,
there is the problem of combining the individual scores. Simple summation may be
appealing, but as pointed out in a seminal paper on social choice, the procedure
would not be appropriate if there were interactions among the individuals so that

182
their scores should really be combined in some other way (Arrow 1963). Because of
the problems associated with interpreting subjective weights in project evaluation,
weighted cost-effectiveness analysis should be used with extreme caution, and the
weights be made explicit.

183
 Chapter Four: Project Implementation, Monitoring and Evaluation
1.1Introduction: What is Monitoring and Evaluation

Throughout life we are monitored and evaluated: in school we receive grades, at work
we are given performance appraisals, and we evaluate relationships and monitor our
health.Before we use the formal definitions of monitoring and evaluation, lets use
common sense definitions: Evaluation asks the question “Are we doing the right thing”
or “Do we have the right plan?” and Monitoring checks to see if we are following our
plan.
Monitoring and Evaluation is the systematic collection and analysis of information to
enable managers and key stakeholders to make informed decisions, maintain existing
practices, policies and principles and improve the performance of their projects.
Monitoring is the regular gathering analyzing and reporting of information that is
needed for evaluation and/or effective project management. Monitoring is either
ongoing or periodic observation of a project’s implementation to ensure that inputs,
activities, outputs, and external factors are proceeding according to plan. It focuses on
regular collection of information to track the project. Monitoring provides information to
alert the stakeholders as to whether or not results are being achieved. It also identifies
challenges and successes and helps in identifying the source of an implementation
problem.
Evaluation is a selective and periodic exercise that attempts to objectively assess the
overall progress and worth of a project. It uses the information gathered through
monitoring and other research activities and is carried out at particular points during the
lifetime of a project.
Evaluation is different from monitoring. Monitoring checks whether the project is on
track; evaluation questions whether the project is on the right track. Monitoring is
concerned with the short-term performances of the project, and evaluation looks more
at long-term effects of project goals. Frequently, evaluation is perceived as an activity,
carried out by an expert or a group of experts, designed to assess the results of a
particular project. This is a common misconception. It is vital that evaluation is carried

184
out with the participation of all project stakeholders, including beneficiaries. The results
of a periodic evaluation are fed into the project planning process as quickly as possible
to enhance the project’s effectiveness.
Monitoring is useful because it tends to highlight little problems before they become big
ones. An evaluation is a systematic examination of a project to determine its efficiency,
effectiveness, impact, sustainability, and the relevance of its objectives. The dictionary
defines evaluation as a systematic investigation of the worth or merit of an activity.
Traditionally, evaluation has been the last step in the project life cycle and in the project
development process. However, it does not make sense to wait until the project is
finished to ask the question “Did we do the right thing?” Indeed, you could evaluate the
effectiveness at each stage of the project life cycle.
In a project the monitoring and evaluation group decides what to monitor. By collecting
data regularly on activity inputs and outputs, processes, and results, the community can
monitor the progress toward the group’s goals and objectives (e.g., income generated
by the sale of a cookbook, how many people sold how many books over what period of
time). In managing a project indicators are indispensable management tools. They
define the data needed to compare the actual verses the planned results.
M&E can be seen as a practical management tool for reviewing performance. M&E
enables learning from experience, which can be used to improve the design and
functioning of projects. Accountability and quality assurance are integral components
of M&E, which help to ensure that project objectives are met, and key outputs and
impacts are achieved.
1.2 Why monitoring and Evaluation
M&E can help an organization to extract, from past and ongoing activities, relevant
information that can be used as the basis for future planning. Without M&E how would it
be possible to judge if a project was going in the right direction, whether progress and
success was being achieved, and how future efforts might be improved?
A structured M&E approach makes information available to support the implementation
of projects and activities and will enhance the sustainability. Used effectively M&E can
help to strengthen project implementation and encourage useful partnerships with key
stakeholders.

185
The main objectives of M&E are thus to:
• Ensure informed decision-making;
• Enhance organizational and development learning;
• Assist in policy development and improvement;
• Provide mechanisms for accountability;
• Promote partnerships with, and knowledge transfer to, key
• Stakeholders;
• Build capacity in M&E tools and techniques.
• M&E is about feedback from implementation.
• The ultimate purpose of M&E is change for the better.
1.3 Different Kinds of Monitoring and Evaluation

M&E can deal with many issues. It can be M&E of Projects. policy implementation, the
performance of a unit in an organization, staff performance or, for example, deliveries
from a subcontractor.This course deals with M&E related to a project. The concepts,
tools, and procedures for project M&E, as presented in this course, also helps to
understand other kinds of M&E.
1.3.1 Internal and External Project M&E
Internal Project M&E is built into the design of a project and is undertaken by the team
that is responsible for management and implementation of the project.This is done to
ensure that the project meets deadlines, stays within the budget and achieves its
objectives, activities, outputs and impacts!. A project that does not monitor its
implementation is not a well-managed project.Findings, recommendations etc of
internal monitoring is usually captured in progress reports submitted by project
management.
External Project M&E is carried out by an outside team, which is not directly responsible
for the management or implementation of the project. External M&E should assess the
effectiveness of the internal M&E put in place by the project management team.
External monitoring can take place once the project has been completed, and/or during
implementation of the project.
External M&E is often required by donor agencies or government organizations if, for

186
example, they need to know how their funds are being spent or if their policies are being
adhered to. All projects can benefit from external M&E.Findings and recommendations
of external monitoring are often documented in a review or evaluation report.External
M&E also monitors and evaluates internal M&E
Figure 4.1: Differences between Internal and External M&E

1.3.2 Monitoring Levels

Traditionally, M&E focused on assessing the inputs and activities of a project. Today the
focus is increasingly on measuring the outputs and impacts of a project to achieve a
broader development objective or goal.Project inputs, activities and assumptions/risks
are also important, however, as they all affect outputs. For example, if the budget (an
input) is cut by 50%, this will obviously affect the outputs of the project and will need to
be taken into account when conducting the M&E. The various monitoring levels in a
project are:
Input Monitoring

187
Input monitoring is the monitoring of the resources that are put into the project - these
include budget, staff, skills, etc. Information on this type of monitoring comes mainly
from management reports, progress reports and accounting.For example, ways of
measuring this can be the number of days consultants are is employed, or the amount
of funds spent on training and equipment.
Activity Monitoring
Activity monitoring monitors what happens during the implementation of the project
and whether those activities which were planned, were carried out. This information is
often taken from the progress report.
Output Monitoring
Output monitoring is a level between activity and impact monitoring. This type of
monitoring assesses the result or output from project inputs and activities.The
measurements used for output monitoring will be those which show the immediate
physical outputs and services from the project.
Impact Monitoring
Impact monitoring relates to the objectives of the project. The aim of impact monitoring
is to analyze whether the broader development objectives of the project have been
met.Such monitoring should demonstrate changes that are fundamental and
sustainable without continued project support.
1.3.3 M&E and Stakeholder Participation
The participatory approach to project management seeks to enable local communities
living adjacent to projects and other local stakeholders to take part in decision-making
and share the benefits of project activities. This participatory approach should also be
applied to M&E. Participatory M&E can play an important role in ensuring that the
participatory principles are put into practice by:
• Improving the effectiveness of project management and decision-making, as the
parties who have been involved in M&E will be informed and aware of the results of
the M&E procedure;
• Ensuring that accurate and reliable information is communicated to communities
and stakeholders from the M&E process;
• Ensuring that stakeholders understand the reasons for failure in achieving project

188
 outputs and objectives and how and what to improve in the future;
• Providing mechanisms for transparency and accountability to stakeholders;
• Building community capacity in M&E tools and techniques.
Recommendations from M&E are more likely to be accepted and taken forward by
stakeholders, if they have had an active role in shaping them.
Activity: Think about a time when you were involved in an evaluation process. What kind
of evaluation was it? What was the evaluation trying to find out? Was the evaluation
participatory?
Did the information gathered and reported get used?
1.4 Procedures in Monitoring and Evaluation
The M&E procedure below sets out the steps in planning and implementing external
M&E. The M&E procedure must be customized to the specific needs of each project,
taking into account the project objectives, inputs, outputs, activities, stakeholders and
beneficiaries. The M&E steps will vary from situation to situation. Seven key steps are
listed in Figure 4.2 and further explained in the rest of this chapter.
The M&E Procedure
Step 1: Establish the Purpose and Scope of M&E
Step 2: Identify Performance Questions and Indicators
Step 3:Establish M&E Functions and Assign
Responsibilities and Financial Resources
Step 4: Gather and Organize Data
Step 5: Analyze Data and Prepare an Evaluation Report
Step 6: Disseminate Findings and Recommendations
Step 7: Learn from the M&E
Step 1: Establish the Purpose and Scope of M&E
Specifying the purpose and scope of the M&E helps to clarify what can be expected of
the M&E procedure, how comprehensive it should be and what resources and time will
be needed to implement it.When formulating the purpose of M&E, relevant stakeholders
including the project management team, should be consulted or at least made aware of
and understand the purpose of the M&E.
Example of an External M&E Purpose

189
To verify that the development objective and outputs of the project have been achieved
within the allocated budget.The scope of the M&E may be determined by asking some
of the following questions:
• What is the purpose of M&E?
• How much money is available for your M&E?
• What type of information is required by project management,
• donor agents or other stakeholders?
• What is the level of M&E expertise available?
• To what extent should local communities and other stakeholders, participate
in the M&E procedure?
Step 2: Identify Performance Questions and Indicators
1. Performance Questions
A performance question is used to focus on whether a project is performing as planned
and if not, why not. Performance questions will be guided by the broader development
objective, the project objectives, the project outputs, as well as the M&E purpose. Once
performance questions have been identified, it will be easier to decide what information
is needed to evaluate the project. Table 4.1 gives examples of performance questions
for the M&E of a particular project.
2. Indicators
Indicators should be guided by performance questions and linked to the purpose of the
M&E. Indicators are basically measurements that can be used to assess the
performance of the project.While performance questions help to decide what should be
monitored and evaluated, indicators provide the actual measurements for M&E and
determine what data needs to be gathered.
The project itself may have indicators by which it monitors it's own progress - these
may be used for external M&E, if relevant. Also the funding organization and other
stakeholders can provide broader indicators that may be relevant to the external M&E of
the project.Indicators, and therefore the data needed to verify them, can be qualitative
or quantitative. Quantitative data is factual while qualitative information is based on
opinions and perceptions and thus may be subject to further interpretation. During M&E,
one should aim to have both qualitative and quantitative indicators. Table 4.1 provides

190
examples of quantitative and qualitative indicators.
Table 4.1: Examples of Quantitative and Qualitative Indicators

INDICATOR
EXAMPLES
TYPES
Quantitative .Fifty bundles of poles are harvested each month.

Indicators .Five training courses were run during the project.

The pole harvesters regard the harvesting system as being
Qualitative
sustainable
Those who attended the training courses perceived the
Indicators
courses to be meeting the demands for skills in the area.

• Relevant - The indicators should be directly linked to the project 0bjectives/ outputs.
• Technically feasible - The indicators should be capable of being verified or measured
and analyzed.
• Reliable - The indicators should be objective: i.e. conclusions based on them should
be the same if different people assess them at different times.
• Usable - People carrying out the M&E should be able to understand and use the
information provided by the indicators to evaluate the project.
• Participatory - Relevant stakeholders should be involved in the collection of
information generated by the indicators, the analysis of the information and possible
use of the information in the future.
Step3: Establish M&E Functions and Assign Responsibilities and Financial Resources
Establishing M&E functions and responsibilities at the beginning of the procedure can
help to avoid major communication issues, conflicts of interest, duplication of tasks and
wasted efforts. Organizing responsibilities means deciding which stakeholders will be
involved and clarifying and assigning roles to these stakeholders as well as to funding
organization officials, project management and any partner organizations. Stakeholders
may need to be trained in different aspects of the M&E procedure
M&E will require financial resources in accordance with the type of project(s) that is
being evaluated as well as the M&E purpose, performance questions and indicators.
Among the items that should be included in M&E costs are:
• Staff salaries;

191
 • Fees and expenses for consultants;
• M&E training;
• Organizing M&E meetings and other participatory exercises.
Consultants can play an important role in enabling projects to fulfill its M&E
responsibilities by providing specialist knowledge and expertise that may not be readily
available in the organization.
Step 4: Gather and Organize Data
Data is the oxygen that gives life to M&E. However, selecting methods of data collection
can be confusing, unless it is approached in a systematic fashion. Rarely is anyone
method entirely suitable for a given situation. Instead, using multiple methods helps to
validate M&E findings and provides a more balanced and holistic view of project
progress and achievements.
The performance questions and indicators will provide guidance in deciding what
data/information to gather and the methods to be used. Data can either be primary or
secondary.
1. Data Sources and Data Collection Methods

Potential data sources and data collection methods are listed below:

• Document Review: Documents and reports provide a rich source of information for
M&E.
• .Interviews: Interviews can provide a rich source of data, particularly in regard to
qualitative and sensitive information that may not be readily available in official
documents.
• Surveys and Questionnaires:Surveys and questionnaires provide a way of obtaining
information from a large number of people. Questions should be relevant and simple
to answer.
• Field Visits and Transect Walks Visits to the site of a project can provide valuable
information about the environment in which the project is taking place, its impact on
beneficiaries and the working methods that are being used. Transect walks are an
effective participatory method to gather this information.
• Expert Opinion Obtaining the views of experts who are knowledgeable about

192
 particular aspects of the project's activities can in some instances provide valuable
insights that may not be revealed by other methods of data collection.
2. Organizing and Storing Data

Data needs to be captured, organized and stored so that it can be readily used for the
M&E purposes. Proper capturing, organizing and storage is particularly important when
information has been collected from different sources with different methods.
Step 5: Analyze Data and Prepare an Evaluation Report
The captured and organized data needs to be analyzed, and findings and
recommendations summarized and compiled into a report.
In this regard, the performance questions and indicators can provide important
assessment tools for the analysis. A final comparison with the outputs and impacts of
the project should then be made. In this way performance, progress and achievements
of the project can be assessed.
Reporting
Feedback and reporting are key to both internal and external M&E as, in this way,
information can be meaningfully combined, explained, compared and presented. All
reporting should thus be as accurate and relevant as possible. As mentioned earlier,
external M&E will frequently use the internal project progress reports and other relevant
information as part of the information gathered to externally monitor and evaluate the
project. For external M&E the report is usually called an evaluation or review report.
Step 6: Disseminate Findings and Recommendations
The evaluation reports, or summaries of these reports, should be widely distributed and
presented to decision-makers and key stakeholders including those who were consulted
in the M&E process.
Step 7: Learn from the M&E
Knowledge gained through M&E lies at the core of DW AF's organizational learning
process. M&E provides information and facts that, when analyzed, understood and
accepted, become knowledge that can be used to improve Project management.
Besides learning about the progress/achievements of the project outputs, etc, it is
essential to learn from what works regarding partnership strategies, project design and
implementation, and to feed this knowledge back into ongoing and future projects and

193
policies. This information also provides a means to regulate the sustainable
management of state projects by other agencies.
Project evaluations can help to bring development partners together, and when this
occurs the learning from M&E goes beyond project to stakeholders involved in other
development and natural resource management activities.
Types of evaluation
Many types of evaluation exist, consequently evaluation methods need to be
customized according to what is being evaluated and the purpose of the evaluation. It is
important to understand the different types of evaluation that can be conducted over a
program’s life-cycle and when they should be used. The main types of evaluation are
process, impact,outcome and Summative evaluation.Before you are able to measure the
effectiveness of your project, you need to determine if the project is being run as
intended and if it is reaching the intended audience.
Process evaluation is used to“measure the activities of the program, program quality
and who it is reaching” . It will help to answer questions about your program such as:
 Has the project reached the target group?
 Are participants and other key stakeholders satisfied with all aspects of the
project?
 Are all activities being implemented as intended? If not why?
 What if any changes have been made to intended activities?
 Are all materials, information and presentations suitable for the target audience?
Impact evaluation is used to measure the immediate effect of the program and is
aligned with the programs objectives. It will help answer questions such as:
• How well has the project achieved its objectives (and sub-objectives)?
• How well have the desired short term changes been achieved?
For example, one of the objectives of Peer-project is to provide a safe space and
learning environment for young people, without fear of judgment, harassment or abuse.
Impact evaluation will assess the attitudes of young people towards the learning
environment and how they perceived it. It may also assess changes in participants’ self
esteem, confidence and social connectedness.
Outcome evaluation is concerned with the long termeffects of the program and is

194
generally used to measure the program goal. It measures how well the program goal
has been achieved.
 Outcome evaluation will help to answer questions such as:
 Has the overall program goal been achieved?
 What, if any factors outside the program have contributed or hindered the
desired change?
In peer-based youth programs outcome evaluation may measure changes to: Mental
and physical wellbeing, Education and employment and help-seeking behaviors.
Summative evaluation: At the completion of the program it may also be valuable to
conduct summative evaluation.This considers the entire program cycle and assists in
decisions such as:
o Do you continue the program?
o Is it possible to implement the program in other settings?
o How sustainable is the program?
o What elements could have helped or hindered the program?
o What recommendations have evolved out of the program?

Chapter Five: Evaluation: Some Basics of impact evaluation

1.1Impact assessment basics

Development policies/projects are typically designed to change outcomes: for example,

raise incomes, improve wellbeing, improving learning, or reducing illness. Whether or
not these changes are actually achieved is a crucial public policy question. Impact
evaluation help policy makers decide whether projects/programs are generating
intended effects. This can be called evidence-based policy. Impact evaluations are
needed to inform policy makers on a range of decisions, from curtailing inefficient
programs, to scaling up interventions that work, to adjusting program benefits, to
selecting among various program alternatives.

Simply, an impact evaluation assesses the changes in the well-beingof individuals that
can beattributed to a particular project, program, orpolicy. This focus on attribution
which is the hallmark of impact evaluations.Correspondingly, the central challenge in

195
carrying out effective impactevaluations is to identify the causal relationship between
the program orpolicy and the outcomes of interest.Impact evaluations generally
estimate average impacts of a program, project, or a design innovation.

Example:

 Did a water andsanitation program increase access to safe water and improve
health outcomes?

 Did a new curriculum raise test scores amongstudents?

 Was theinnovation of including noncognitive skills as part of a youth training

program successful in fostering entrepreneurship and raising incomes?

Ineach of these cases, the impact evaluation provides information onwhether the
program/project caused the desired changes in outcomes, as contrasted with specific
case studies, which can give only partialinformation and may not be representative of
overall program impacts. Inthis sense, well-designed and well-implemented impact
evaluations areable to provide convincing and comprehensive evidence thatcan be
usedto inform policy decisions, shape public opinion, and improve programoperations.

Impact evaluations are a particular type of evaluation that seeks to answer a specific
cause-and-effect question: What is the impact (or causal effect) of a program on an
outcome of interest? This basic question incorporates an important causal dimension.
The focus is only on the impact: that is, the changes directly attributable to a program,
program modality, or design innovation.
The basic evaluation question—what is the impact or causal effect of a program on an
outcome of interest?—can be applied to many contexts. For instance:

 what is the causal effect of scholarships on school attendance and academic

achievement?

 What is the impact of contracting out primary care to private providers on access
to health care? If dirt floors are replaced with cement floors, what will be the

196
 impact on
children’s health?

 Do improved roads increase access to labor markets and raise households’

income, and if so, by how much?

 Does class size influence student achievement, and if it does, by how much?

As these examples show, the basic evaluation question can be extended to examine the
impact of a program modality or design innovation, not just a program. The focus on
causality and attribution is the hallmark of impact evaluations. All impact evaluation
methods address some form of cause-and-effect question. The approach to addressing
causality determines the methodologies that can be used. To be able to estimate the
causal effect or impact of a program on outcomes, any impact evaluation method
chosen must estimate the so-called counterfactual: that is, what the outcome
would have been for program participants if they had not participated in the program. In
practice, impact evaluation requires that the evaluation team find a comparison group
to estimate what would have happened to the program participants without the
program, then make comparisons
with the treatment group that has received the program.
1.1.1 Qualitative versus quantitative impact Assessments

Most interventions have far-reaching goals such as lowering poverty or

increasing employment. Measuring the effectiveness of such interventions are
often possible only through impact evaluations based on hard evidence.
Qualitative information such as understanding the local socio-cultural &
institutional context, program & participant details, essential to a sound
quantitative assessment. e.g., qualitative information can help identify
mechanisms through which programs might be having an impact. But, a
qualitative assessment on its own cannot assess outcomes against relevant
alternatives or counterfactual outcomes. That is, it cannot really indicate what
might happen in the absence of the program. A mixture of qualitative and
quantitative methods (a mixed-methods approach) might therefore be useful in

197
gaining a comprehensive view of the program’s effectiveness.

1.2Methodologies in impact evaluation

Before looking themethodologies of impact evaluation, it is necessary to discuss

the initial steps in setting up an evaluation. The steps include constructing a
theory of change that outlines how the project is supposed to achieve the
intended results, developing a results chain as a useful tool for outlining the
theory of change, find a relevant counterfactual, selection of respondents,
collecting relevant data, and finally, there should be rigorous analysis (measuring
impact with appropriate methodological approach). Since it is new for you as a
Bachler student, we have discussed the first three steps as follows.
1. Constructing a Theory of Change

198
A theory of change is a description of how an intervention is supposed to deliver
the desired results. It describes the causal logic of how and why a particular
program, project, or design innovation will reach its intended outcomes. A theory
of change is a key underpinning of any impact evaluation, given the cause-and-
effect focus of the research. As one of the
first steps in the evaluation design, constructing a theory of change can help
specify the research questions. Theories of change depict a sequence of events
leading to outcomes; they explore the conditions and assumptions needed for
the change to take place, make explicit the causal logic behind the program, and
map the program interventions along logical causal pathways.
2. Developing a Results Chain

A results chain is one way of depicting a theory of change. A results chain

establishes the causal logic from the initiation of the program, beginning with
resources available, to the end, looking at long term goals. It sets out a logical,
plausible outline of how a sequence of inputs, activities, and outputs for which a
program is directly responsible interacts with behavior to establish pathways
through which impacts are achieved. The result chain in a typical program is
resented as follow:

199
A basic results chain will map the following elements:

 Inputs. Resources at the disposal of the project, including staff and

budget.

 Activities. Actions taken or work performed to convert inputs into outputs.

 Outputs. The tangible goods and services that the project activities
produce; these are directly under the control of the implementing agency.

 Outcomes. Results likely to be achieved once the beneficiary population

uses the project outputs; these are usually achieved in the short to
medium term and are usually not directly under the control of the

200
 implementing agency.

 Finaloutcomes. The final results achieved indicating whether project

goals were met. Typically, final outcomes can be influenced by multiple
factors and are achieved over a longer period of time.
3. Finding the right Counterfactual

Counterfactual: What would have happened to the participants of an intervention had

they not received the intervention. The counterfactual can never be observed; it can only
be inferred from a control / comparison group different from the treatment group.
Control group: In an experimental design, the control group is a group from the same
population as the treatment group that, by random assignment, is not intended to
receive the intervention.
Comparison group: A group that is as similar as possible to the treatment group in
order to be able to learn about the counterfactual.
Treatment group: Group that receives the intervention.
Impact:The impact of the intervention is,therefore, estimated by measuring the
differences in outcomes between the treatment and comparison groups.
Causal Inference andCounterfactuals
CausalInference
Assessing the impact of a program on a set of outcomes is theequivalent of assessing
the causal effect of the program on those outcomes.Although cause-and-effect
questions are common, answering them accurately can be challenging. In the context of
a vocational training program (Do vocational training programs increase trainees’
incomes?), forexample, simply observing that a trainee’s income increases after she
hascompleted such a program is not sufficient toestablish causality. The
trainee’sincome might have increased even if she had not taken the training—becauseof
her own efforts, because of changing labor market conditions, or because
of many other factors that can affect income. Impact evaluations help us overcome
thechallenge of establishing causality by empirically establishing towhat extent a
particular program—and that program alone— contributed to the change in an outcome.
To establish causality between a program and anoutcome, we use impact evaluation

201
methods to rule out the possibility thatany factors other than the program of interest
explain the observed impact.The answer to the basic impact evaluation question—what
is the impact
or causal effect of a program (P) on an outcome of interest (Y)? —is given bythe basic
impact evaluation formula:
Δ = (Y | P = 1) - (Y | P = 0).
This formula states that the causal impact (Δ) of a program (P) on anoutcome (Y) is the
difference between the outcome (Y) with the program (inother words, when P = 1) and
thesame outcome (Y) without the program(that is, when P = 0).For example, if P
denotes a vocational training program and Y denotesincome, then the causal impact of
the vocational training program (Δ) is thedifference between a person’s income (Y) after
participation in thevocational training program (in other words, when P = 1) and the
same person’sincome (Y) at the same point in time if he or she had not participated in
theprogram (in other words, when P = 0).
The Counterfactual
As discussed, we can think of the impact (Δ) of a program as the difference in
outcomes (Y) for the same unit (person, household, community, and so on) with and
without participation in a program. Yet we know that measuring the same unit in two
different states at the same time is impossible. At any given moment in time, a unit
either participated in the program or did not participate. The unit cannot be observed
simultaneously in two different states (in other words, with and without the program).
This is called the counterfactual problem.
When conducting an impact evaluation, it is relatively straightforwardto obtain the first
term of the basic formula (Y | P = 1). However, we cannot directlyobserve the second
term of the formula (Y | P = 0) for the participant.We need to fill in this missing data by
estimating thecounterfactual.
Estimating the counterfactual
The key to estimating the counterfactual for program participants is to move from the
individual or unit level to the group level.Although no perfect clone exists for a single
unit, we can rely on statistical properties to generate two groups of units that are
statistically indistinguishable from each other at the group level (if their numbers are

202
large enough).The challenge of an impact evaluation is therefore to identify a treatment
group and a comparison group that are statistically identical, on average, in the absence
of the program.If the two groups are identical, with the sole exception that one group
participates in the program and the other does not, then we can be sure that any
difference in outcomes must be due to the program.Finding such comparison groups is
the crux (core) of any impact evaluation, regardless of what type of program is being
evaluated.Without a comparison group that yields an accurate estimate of the
counterfactual, the true impact of a program cannot be established.
• The treatment and comparison groups must be the same in at least three ways.

1. The average characteristics of the treatment group and the comparison group
must be identical in the absence of the program.For example, the average age of
units in the treatment group should be the same as in the comparison group.

2. The treatment should not affect the comparison group either directly or
indirectly.In the pocket money example, the treatment group should not transfer
resources to the comparison group (direct effect) or affect the price of candy in
the local markets (indirect effect).

3. The outcomes of units in the control group should change the same way as
outcomes in the treatment group, if both groups were given the program (or
not).For example, if incomes of people in the treatment group increased by $100
thanks to a training program, then incomes of people in the comparison group
would have also increased by $100, had they been given training.

What if the counterfactual is not good?

An invalid comparison group is one that differs from the treatment group in some
way other than the absence of the treatment. Those additional differences can
cause the estimate of impact to be invalid or, in statistical terms, biased. Rather, it
will estimate the effect of the program mixed with those other differences.
1.2.1 Randomized evaluations

What is randomization?
Randomization involves randomly assigning a potential participant (individual,

203
household or village) to the treatment or control group. It gives each potential
participant an equal chance of being assigned to each group. The objective is to ensure
that the only systematic difference between the program participants (treatment) and
non-participants (control) is the presence of the program.
The Basic Treatment Effect Setup
Let us consider whether receiving a job training program increases wages. We compare
two people, the person in the training program and the one who is not, to determine
whether their outcomes are different. If these two people were identical, except for
exposure to the program, then the observed difference in their wages would be the
treatment effect. It is abinary treatment where a person is treated or not (ie, in a job
training program, and the like).
Let Yjidenote the potential outcome of individual iin statej (unobserved):
• Y1i if individual iparticipated in the job training program

• Y0i if individual ihad not participated in the job training program

To identify the individual treatment effect, we needdi, Y1i,Y0i, (Xi and ui) for individual i. In
practice, we only observe di, Yi, (Xi). Therefore, in a given sample, the group with di=1
that reveals (Xi,Y1i) is the treatment group and the group with di=0 that reveals (Xi,Y0i)
is the control group. Ideally we would measure the individual treatment effect for
–
individual ias: Y1i Y0i , which can be rewritten as:
• Yi =diY1i + (1- di)Y0i

• Yi = diY1i + Y0i- diY0i Yi= Y0i + di(Y1i-Y0i)

But we don’t observe two potential outcomes for the same individual, only Y1i for the
treated person and Y0iif not. We do observe the difference in average outcomes (wages)
for groups of people treated (or not). So, we can measure average treatment effects:
• E(Yi|di=1) – E(Yi|di=0)

This can be rewritten in a potential outcomes framework: (Add and subtract the
expected outcome for non- participants had they participated in the program i.e.,
E(Y0i|di=1)
[E(Y1i|di=1) – E(Y0i|di=1)] + [E(Y0i|di=1) – E(Y0i|di=0)]
Average Treatment Effect Selection bias

204
 on the Treated (ATT)
Average difference in Y0i (potential
Impact of program for those untreated outcomes) for those who were
alreadyin theprogramDifference in and were not in theprogram
potential outcomes, conditional
Average Treatment Effect on the Treated (ATT)measures the impact of a program for
ontreatment
those in the program:
E(Y1i|di=1) – E (Y0i|di=1) = E(Y1i-Y0i |di=1)
It is the difference in the potential outcomes, conditional on treatment.The first
expression is what we observe; but the problem is the second expression. Why?
Because, It is the average wage of a person in a job training program if they had not
been trained. Even if we can measure the ATT, we also have to worry about selection
bias:
[E(Y0i|di=1) – E(Y0i|di=0)]
In this selection bias equation, the second expression is what we observe; but the
problem is the first expression. Because it is the average wage of a person in a job
training program had they not been trained
To solve this problem, the researcher uses randomization: randomly assigning a
potential participant to the treatment or control group. Therefore, Randomization
implies that:
E[Y0i|di=1] = E[Y0i|di=0]
This is because, if neither had received the treatment, their outcomes would have been
the same in expectation (treatment is independent of potential outcomes).Individuals
assigned to the Treatment and Control groups will be similar along all characteristics (X
and u). Randomization therefore forces the selection bias term to be zero. More
specifically, look at the following expression.
[E(Y1i|di=1) – E(Y0i|di=1)] + [E(Y0i|di=1) – E(Y0i|di=0)]
=[E(Y1i-Y0i|di=1)] + [E(Y0i|di=1) – E(Y0i|di=0)]
= [E(Y1i-Y0i|di=1)] + [E(Y0i|di=0) – E(Y0i|di=0)]
= [E(Y1i -Y0i|di=1)]
=E(Y1i -Y0i)
= E(Y1i) – E(Y0i)

205
So, if there is randomization, then we can calculate the Average Treatment Effect on the
treated (ATT) and also the Average Treatment Effect (ATE) by riding the selection bias
to zero.The Average Treatment Effect (ATE) is estimated as:
E(Y1-Y0) = E(Y1) - E(Y0).
This shows that, with randomization, Average Treatment Effect (ATE) is equal to the
Average Treatment Effect on the treated (ATT).
Measuring the Average Treatment Effect on the treated (ATT)
The treatment effect (ATT) can be measured by using two approaches:Group means
comparison and/or regression analysis. That is an unbiased estimate of the treatment
effect can be identified by simple group mean differencing like as follows:
ATT = [E(Y1i-Y0i|di=1)] = E(Y1i-Y0i) = E(Y1i) - E(Y0i)
= E(Y1|d=1) -E(Y0|d=0)
In addition to this We can also estimate the ATT under a regression framework:
Yi = γ + αdi + ui
Where, γ is the mean of the control group, α is the difference between Y1i and Y0i ,u is the
random part. this expression can be rewritens by plugging values for d and taking
expectations:
E(Yi|di=1) = γ + α + E(ui|di=1) E(Yi|di=0) = γ + E(ui|di=0)
And then subtracting:

If the independence assumption holds, then the selection bias term equals zero. Then
our expression becomes: E(Yi|di=1) - E(Yi|di=0) = α. The magnitude of the treatment
effect (α) using the group means comparison or regression analysis should be equal if
other explanatory variables will not be included in the regression equation. Look at the
following ttest and regression output.

206
 1.2.2 Matching Methods- Propensity score matching (PSM)

Matching methods compares the outcomes of adopters with those of matched non-
adopters, where matches are chosen on the basis of similarity on observed
characteristics. That is, the comparison group needs to be as similar as possible to the
treatment group, in terms of the observables before the start of the treatment. The
method assumes there are no remaining unobservable differences between adopters
and non-adopters. Let us see the following tables which shows exact Matching between
the treated and untreated groups on four characteristics.

207
 Source: Gertler et, al., 2016
Propensity score matching (PSM)
Propensity score is defined as the selection probability conditional on the confounding
variables:p(X) = p(D = 1|X). PSM constructs a statistical comparison group that is based
on a model of the probability of participating in the treatment, using observed
characteristics (Heckman et al., 1998; Smith & Todd, 2001). Participants are then
matched on the basis of this probability, or propensity score, to nonparticipants. There
are two Fundamental assumptions:
1. Conditional independence (selection on observables) assumption: (Ya ,Yn) ^ D |X

2. Common support assumption: 0 <p(X) = prob(D = 1|X) <1. This ensures that trt
observations have comparison observations nearby in the propensity score
distribution.

208
Different approaches are used to match participants and nonparticipants on the basis
of the propensity score. They include nearest-neighbor (NN) matching, caliper and
radius matching, stratification and interval matching, and kernel matching and local
linear matching (LLM). Regression-based methods on the sample of participants and
nonparticipants, using the propensity score as weights, can lead to more efficient
estimates (Heckman, LaLonde, and Smith 1999; Shahidur et al., 2010).
Propensity score: To calculate the program treatment effect in PSM, we must first
calculate the propensity score P(X) on the basis of all observed covariates X that jointly
affect participation and the outcome of interest. The aim of matching is to find the
closest comparison group from a sample of nonparticipants to the sample of program
participants (Gertler et al., 2016). Propensity score can be estimated by using probit or
logit regression. However, PSM has limitation. That is, PSM assumes selection on
observables; but selection on unobservables happens which leads to biased result.

209
References

1. Bahir Dar University Module on project planning and analysis II, department of
economics.

2. Economic Analysis of projects, a world bank research publication

3. Gertler, Paul J., Sebastian Martinez, Patrick Premand, Laura B. Rawlings, and Christel
M. J. Vermeersch. 2016. Impact Evaluation in Practice, second edition. Washington,
DC: Inter-American Development Bank and World Bank. doi:10.1596/978-1-4648-
0779-4. License: Creative Commons Attribution CC BY 3.0 IGO

4. I.M.D Little and J.A. Mirrlees, project Appraisal and planning for developing
countries., New Delhi Lusaka, 1974

5. Prasanna chandra, projects planning analysis, selection, implementation and review,

New Delhi, 1995

6. Shahidur R. Khandker, Gayatri B. Koolwal& Hussain A. Samad (2010); Handbook on

Impact Evaluation; Quantitative Methods and Practices. The World Bank,
Washington DC.
7. W.Behrens, P.M Hawranek, Manual for the preporation of Industrial feasibility
studies UNIDO publication

210
211
212