CHAPTER 14

SOCIAL COST BENEFIT ANALYSIS

 OUTLINE
• Rationale for SCBA
• UNIDO approach
• Net benefit in terms of economic (efficiency) prices
• Savings impact and its value
• Income distribution impact
• Adjustment for merit and demerit goods
• Little-Mirrlees approach
• Shadow prices
• SCBA by financial institutions
• Public sector investment decisions in India
 Rationale for SCBA

In SCBA the focus is on the social costs and benefits of the project.
These often tend to differ from the monetary costs and benefits of the
project. The principal sources of discrepancy are :
     Market imperfections
     Externalities
     Taxes and subsidies
 Concern for savings
 Concern for redistribution
erit wants
 UNIDO Approach
The UNIDO method of project appraisal involves five stages:
1. Calculation of the financial profitability of the project measured at
market prices.
2. Obtaining the net benefit of the project measured in terms of economic
(efficiency) prices.
3. Adjustment for the impact of the project on savings and investment
4. Adjustment for the impact of the project on income distribution
5. Adjustment for the impact of the project on merit goods and demerit
goods whose social values differ from their economic values.
Each stage of appraisal measures the desirability of the project from a
different angle.
 Net Benefits in Terms of Economic
(Efficiency) Prices
Shadow Pricing : Basic Issues
• Choice of numeraire
• Concept of tradability
• Concept of shadow prices
• Taxes
• Consumer willingness to pay
Shadow Pricing of Specific Resources
• Tradable inputs and outputs
• Non-tradable inputs and outputs
• Externalities
• Labour inputs
• Capital inputs
• Foreign exchange
 Illustration
Presently, a ferry service, operated privately, is being used to cross a river.
The ferry operator charges Rs.3 per person. It costs him Rs.2 per person.
50,000 persons use the ferry service. (This means that the number of persons
crossing the river by ferry service throughout the year is 50,000)
The government is considering construction of a bridge over the river. It is
estimated that after the bridge is constructed 2,50,000 persons will cross the
river on the bridge. The bridge is expected to cost Rs 3 million initially and its
annual maintenance cost would be Rs 10,000. It has an indefinitely long life.
Once the bridge is constructed the ferry operator is expected to close down the
ferry service and sell the ferry boats for Rs.100,00.

Required : Define the social costs and benefits of constructing the

bridge, assuming that the monetary figures given in the
problem represent economic values.
Solution : The social costs and benefits of bridge construction may be
defined as follows:
Costs
These consists of the following:
1. Construction cost : Rs.3,000,000 (This is a one-shot cost)
2. Maintenance cost : Rs. 10,000 (This is an annual cost)
Benefits
These consist of the following :
1. Value of ferries released : Rs 100,000 ( This is one-shot benefit)
2. Savings in the cost of ferry operation: Rs 100,000 (This is an annual
benefit)
3. Increase in consumer satisfaction: This is equal to willingness to pay of
200,000 additional persons who are expected to use the bridge. Since the
first additional person is willing to pay almost Rs 3 (the charge of the ferry
operator) and the late person is willing to pay almost nothing (there is no
toll for using the bridge) the average willingness to pay of additional users,
assuming that the demand schedule is linear, is Rs. 1.50. So the willingness
to pay of 200,000 additional persons is is 200,000 x Rs 1.50 = 300,000.
 Measurement of the Impact on Distribution
Stages three and four of the UNIDO method are concerned with measuring the value of
a project in terms of its contribution to savings and income redistribution. To facilitate
such assessments, we must first measure the income gained or lost by individual groups
within the society
For income distribution analysis, the society may be divided into various groups. The
UNIDO approach seeks to identify income gains and losses by the following:

• Project
• Other private business
• Government
• Workers
• Consumers
[
• External sector

The gain or loss to an individual group within the society as a result of the project is
equal to the difference between the shadow price and the market price of each input or
output in the case of physical resources or the difference between the price paid and the
value received in the case of financial transactions.
 Savings Impact and its Value

Most of the developing countries face scarcity of capital. Hence, the

governments of these countries are concerned about the impact of a
project on savings and its value thereof. Stage three of the UNIDO
method, concerned with this, seeks to answer the following questions:
• Given the income distribution impact of the project
what would be its effect on savings?
• What is the value of such savings to the society?
 Impact on Savings
The savings impact of a project is equal to:
 i MPSi
Where i = change in income of group i as a result of the project
MPSi = marginal propensity to save of group i
Example As a result of a project the income gained /lost by four groups
is : Group 1 = Rs. 100,000 Group 2 = Rs 500,000, Group 3 = -
Rs.200,000 and Group 4 = -Rs 400,000. The marginal propensity to save
of these four groups is as follows:
MPS1 = 0.05, MPS2 = 0.10, MPS3 = 0.20, and MPS4 = 0.40
The impact on savings of the project is:
100,000 x 0.05 + 500,000 x 0.10 – 200,000 x 0.20 –
400,000 x 0.40 = - Rs.1,45,000
 Value of Savings
r(1-a) r(1-a)(1+ar) r(1-a)(1+ar)n-1
I = + +…..+ +…….
(!+k) (1+k)2 (1+k)n
r(1-a)
(1+k) r(1-a)
= =
(1+ar) (k-ar)
1-
(1+k)
Where I = social value of savings (investment)
r = marginal productivity of capital
a = reinvestment rate on additional income arising
from investment
k = social discount rate
 Income Distribution Impact

Many governments regard redistribution of income in favour of

economically weaker sections or economically backward regions as a
socially desirable objective. Due to practical difficulties in pursuing the
objective of redistribution entirely through the tax, subsidy, and transfer
measures of the government, investment projects are also considered as
investments for income redistribution and their contribution toward this
goal is considered in their evaluation. This calls for suitably weighing
the net gain or loss by each group, measured earlier, to reflect the
relative value of income for different groups and summing them.
In general, the weight attached to an income is given by the
formula:
b n

wi
ci
Where wi = weight attached to income at ci level
b = base level of income that has a weight of 1
n = elasticity of the marginal utility of income
 Adjustment for Merit and Demerit Goods
In some cases, the analysis has to be extended beyond stage four to
reflect the difference between the economic value and social value
of resources. The difference exists in the case of merit goods and
demerit goods. A merit good is one for which the social value
exceeds the economic value. For example, a country may place a
higher social value than economic value on production of oil because
it reduces dependence on foreign supplies. The concept of merit
goods can be extended to include a socially desirable outcome like
creation of employment. In the absence of the project, the
government perhaps would be willing to pay unemployment
compensation or provide mere make-work jobs.
In case of a demerit good, the social value of the good is less than
its economic value. For example, a country may regard alcoholic
products as having a social value less than the economic value.
 Little-Mirrlees Approach
There is considerable similarity between the UNIDO approach and the L-M approach.
Both the approaches call for:
1. Calculating accounting (shadow) prices particularly for foreign
exchange savings and unskilled labour.
2. Considering the factor of equity
3. Use of DCF analysis
Despite considerable similarities there are certain differences between the two
approaches:
1. The UNIDO approach measures costs and benefits in terms of domestic
rupees whereas the L-M approach measures costs and benefits in terms of
international prices, also referred to as border prices.
2. The UNIDO approach measures costs and benefits in terms of
consumption whereas the L-M approach measures costs and benefits in
terms of uncommitted social income.
3. The stage-by-stage analysis recommended by the UNIDO approach focuses
on efficiency, savings, and redistribution considerations in different stages.
The L-M approach, however, tends to view these considerations together.
 Shadow Prices

• The outputs and inputs of a project are classified into the following
categories: traded goods and services, non-traded goods and services,
and labour.
• The shadow price of a traded good is simply its border price
• The shadow (or accounting) price of a non-traded item is defined in
terms of marginal social cost and marginal social benefit.
 Use of Conversion Factors

Ideally, the accounting price of a non-traded item is defined in terms of

marginal social cost and marginal social benefit. In practice, the
calculation of marginal social cost and marginal social benefit is often a
difficult task. As a practical expedient, L-M suggest that the monetary
cost of a non-traded item be broken down into tradable,labour, and
residual components. The tradable and residual components may be
converted into social cost by applying suitable social conversion factors;
the labour component’s social cost can be obtained by using social wage
rate
 Shadow Wage Rate
The shadow wage rate is an important but difficult-to-determine element in
social cost benefit analysis. It is a function of several factors: (i) the
marginal productivity of labour, (ii) the cost associated with urbanisation
(cost of transport,urban overheads, etc.), and (iii) the cost of having an
additional amount committed to consumption when the consumption of the
worker increases as a result of the higher income he enjoys in urban
employment.
L-M suggest the following formula for calculating the shadow wage rate:
SWR = c’ – 1/s (c-m)
Where SWR = shadow wage rate
c’ = additional resources devoted to consumption
1/s = value of a unit of committed resource
c = consumption of the wage earner
m = marginal product of the wage earner
 Accounting Rate of Return
The accounting rate of return (interest) is the rate used for discounting
social profits. In determining the accounting rate of return the
following considerations should be borne in mind:
• The future social profit for all projects must be discounted in
the same way
• The accounting rate(s) of interest should be such that all
mutually compatible projects with positive present social value
can be undertaken.
• The accounting rate of interest should maintain some kind of
balance between investment and investible resources: too low
an accounting rate of interest would lead to over-investment
with inflationary effects and too high an accounting rate of
interest would leave savings under-utilised and result in
excessive unemployment.
 SCBA by Financial Institutions
The all India term-lending financial institutions, IDBI, IFCI, and ICICI (IDBI
and ICICI have now become universal banks) appraise projects primarily from
the financial point of view. However, they also scrutinise projects from the
larger social point of view. ICICI was perhaps the first financial institution to
introduce a system of economic analysis as distinct from financial profitability
analysis. IFCI adopted a system of economic appraisal in 1979. Finally, IDBI
also introduced a system for economic appraisal of projects financed by them.
Though there are some minor variations, the three institutions follow
essentially a similar approach which is a simplified version of the L-M
approach. We shall describe the appraisal procedure followed by IDBI.
IDBI, in its economic appraisal of industrial projects, considers three aspects:
• Economic rate of return
• Effective rate of protection
• Domestic resource cost
 Economic Rate of Return
The method followed by IDBI to calculate the economic rate of return may
be described as a ‘Partial Little-Mirrlees’ method because while
international prices are used for valuation of tradable inputs and outputs, L-
M method is not followed in its entirety. The significant elements of IDBI’s
method are described below:
1. International prices are regarded as the relevant economic prices
and, hence, it is necessary to substitute market prices with
international prices for all non-labour inputs and outputs
2. For tradable items, where international prices are directly available,
CIF prices are used for inputs and FOB prices are used for outputs
3. For tradable items where international prices are not directly
available and for non-tradable items (like electricity, transportation,
etc.), social conversion factors are used to convert actual rupee cost
into social cost.
 Effective Rate of Protection
Tariffs, import restrictions, and subsidies are used to encourage domestic
industries and protect them against international competition. The extent to
which a project is sheltered is measured by the Effective Rate of Protection
(ERP) . It is calculated as follows:
Value added at domestic prices - Value added at world prices
Value added at world prices
This ratio is multiplied by 100 to express the ERP in percentage terms.
The data required for calculating the ERP may be arranged as follows:
At domestic prices At world prices
A. Selling price
B. Input cost: Traded
Non-traded
C. Value added
 Domestic Resources Cost
Domestic resources cost (DRC) reflects the domestic cost incurred per unit of
foreign exchange saved or earned. Financial institutions use the following
formula to calculate DRC
 
A+B+C
DRC = x Exchange rate
P – (Q + R + S + T)
 
Where A = annual charge on domestic capital calculated at the rate of
10 percent.
B = annual depreciation on domestic capital assets (other than
land) calculated at the rate of 8 percent
C = annual cost of non-traded inputs
P = sales realisation at international prices
Q = annual charge on imported capital assets at the rate of 10
percent
R = annual depreciation on imported capital assets at the rate of 8
percent
S = annual cost of imported inputs
T = annual cost of domestically procured, but tradable inputs  
 Public Sector Investment Decisions in India
Very broadly the principal steps in the public investment decision making process
in India are as follows:
1. The Planning Commission formulates the five-year plan indicating the
broad strategy of planning, the role of each sector, the physical targets to be
achieved by each sector, and the financial outlays to be made available for
the development of each sector.
2. The administrative ministries develop sectoral plans. It is in these plans that
the projects of the public sector enterprises are identified. The
identification of a project provides the green signal for the preparation of
its feasibility report.
3. The concerned public sector enterprise prepares the feasibility report and
forwards it to its administrative ministry.
4. The administrative ministry carries out a preliminary scrutiny of the
feasibility report and sends copies of the same to the various appraising
agencies, namely, the Planning Commission, the Department of Economic
Affairs and the Plan Finance Division of the Finance Ministry, and the
Bureau of Public Enterprises for their comments.
5. The PAD of the Planning Commission carries out a detailed appraisal.
The objective of its appraisal is not only to suggest whether to accept
or reject the project but also to suggest how it may be re-formulated to
enhance its technical, financial, commercial, and economic viability.
6. The Investment Planning Committee of the Planning Commission
discusses the appraisal note of the PAD and recommends to the PIB
the view of the Planning Commission on whether the project should be
accepted, rejected, deferred, reformulated, or redesigned.
7. The PIB considers the (a) appraisal note of the PAD along with the
view of the planning Commission, (b) the comments of the BPE, (c)
the comments of the plan finance division of the ministry of finance,
and (d) the note of the administrative ministry. If the PIB clears the
project, it sends it to the cabinet for its approval
8. The cabinet generally accepts the recommendation of the PIB and
approves its implementation.
 SUMMARY
 In SCBA the focus is on social costs and benefits of a project. These often tend to
differ from the costs incurred in monetary terms and benefits earned in monetary
terms by the project. The principal reasons for discrepancy are: (i) market
imperfections, (ii) externalities, (iii) taxes, (iv) concern for savings, (v) concern for
redistribution, and (iv) merit and demerit goods

 Towards the end of the sixties and early seventies two principal approaches for
SCBA emerged : UNIDO approach and Little- Mirrlees approach.
 The UNIDO method of project appraisal involves five stages: (i) calculation of the
financial profitability of the project measured at market prices; (ii) obtaining the net
benefit of the project measured in terms of economic (efficiency) prices; (iii)
adjustment for the impact of the project on savings and investment; (iv) adjustment
for the impact of the project on income redistribution; and (v) adjustment for the
impact of the project on merit and demerit goods.

 As per the L-M approach, the outputs and inputs of a project are classified into the
following categories: (i) traded goods and services, (ii) non-traded goods and
services, and (iii) labour.
 The shadow price of a traded good is simply its border price. If a good is exported
its shadow price is its FOB price and if a good is imported its shadow price is its
CIF price. The shadow prices for non-traded items are defined in terms of
marginal social cost and marginal social benefit.
 The L-M approach suggests the following formula for calculating the shadow
wage rate (SWR) SWR = c’ – 1/s (c-m)
 While the all-India term-lending institutions – IDBI, IFCI, and ICICI- approach
project proposals primarily from the financial point of view, they also evaluate
them from the larger social point of view.
 Though there are some minor variations, the three institutions follow essentially a
similar approach which is a simplified version of the L-M approach.
 IDBI, the apex term-lending financial institutions, considers three aspects in its
economic appraisal of industrial projects: economic rate of return, effective rate
of protection, and domestic resource cost
 The economic rate of return is simply the internal rate of return of the stream of
social costs and benefits.
 The effective rate of protection is calculated as follows: Value added at domestic
prices - Value added at world prices Value added at world prices.
 Till the middle of the sixties the mechanism for appraisal and selection of public
sector projects was rather primitive. To improve the quality of project planning
and strengthen the public investment decision making process several steps were
taken: creation of the Bureau of Public Enterprises; establishment of the Project
Appraisal Division (PAD) in the Planning Commission; and institution of the
Public Investment Board (PIB).