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SOCIAL COST BENEFIT ANALYSIS (SCBA)

SCBA, called economic analysis, is a methodology


developed for evaluating investment projects from the point
of view of the society or economy as a whole. SCBA is
relevant to developing countries where governments are
playing a significant role in the economic development. It is
also relevant to private investments as these have to be
approved by various governmental and quasi-governmental
agencies which bring to bear larger national considerations
in their decisions.
SCBA aids in evaluating individual projects within the
planning framework which spells out national economic
objectives and broad allocation of resources to various
sectors. SCBA is concerned with tactical decision making
within the framework of broad strategic choices defined by
planning at the macro level. The perspectives and
parameters provided by the macro level plans serve as the
basis for analyzing and appraising individual projects.
1. Rationale for SCBA
In SCBA the focus is on the social costs and benefits of the
project. These often tend to differ from monetary costs and
benefits of the project. The major sources of discrepancy are:
 Market imperfections
 Externalities
 Taxes and subsidies
 Concern for savings
 Concern for redistribution
 Merit wants
Market Imperfections:
Where market imperfections exist, market prices do not
reflect social values. The common market imperfections
are:
• Rationing
• Prescription of minimum wage rates, and
• Foreign exchange regulation
All these factors are relevant to SCBA
Externalities
A project may have beneficial as well as harmful
effects. Though these are ignored in assessing the monetary
benefits to the project sponsors, in SCBA, externalities
are relevant as in such analysis all costs and benefits,
irrespective whom they accrue and whether they are paid
for or not, are relevant.
Taxes and Subsidies
Taxes are monetary costs and subsidies are monetary
gains. From the social point of view, however, taxes and
subsidies are generally regarded as transfer payments and
hence considered irrelevant.
Concern for Savings
Unconcerned about how its benefits are divided between
consumption and savings, a private firm does not put
differential valuation on savings and consumption. From a
social angle, the division of benefits between consumption
and savings ( which leads to investment ) is relevant.
In SCBA a higher valuation is placed on savings and lower
valuation is put on consumption.
Concern for Redistribution
A private firm does not bother how its benefits are
distributed across various groups in the society. A rupee
benefit going to an economically poor section is considered
more valuable than going to an affluent section.
Merit wants
Goals and preferences are not expressed in the
market place, but believed by policy makers to be in the
larger interest, may be referred to as merit wants. These
are important from the social point of view.
2. UNIDO APPROACH
The UNIDO method of project appraisal involve five stages:
1. Calculation of the financial profitability of the project
measures at market prices.
2. Obtaining the net benefit of the project measured in
terms of economic (shadow or 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.
3. Net Benefit in terms of Economic (Efficiency) Prices
UNIDO approach (second stage) is concerned with the
determination of the net benefits of the project in terms of
economic prices, also referred to as shadow prices.
It may be noted that market prices represent shadow
prices only under conditions of perfect markets which are
almost invariably not fulfilled in developing countries.
Shadow Prices: Basic Issues
Choice of Numeraire
It is the unit of account in which the value of inputs
outputs is expressed. To define or numeraire, the
following questions have to be answered:
i) Unit of currency- domestic or foreign to express benefits
and costs.
ii) Measurement of benefits in current or constant values
iii) Evaluation with reference to which point- present or
future.
iv) Use- consumption or investment will be made of the
income from the project.
v) Group – should the income of the project be measured
The specification of the UNIDO numeraire in terms of the
above questions is “ net present consumption in the hands
of people at the base level of consumption in the private
sector in terms of constant price in domestic accounting
rupees.”
Fundamental of Shadow Pricing:
Tradability:
It is where good is tradable i.e. whether it can be imported
or exported. A good is said to be tradable, if the good can be
imported instead of domestic production and can be
exported instead of domestic consumption. The economic
opportunity cost or its real value to the country in terms of
pure efficiency of such good is the international price.
Tradable:
A good that would be imported or exported in the absence
of trade barriers and quantitative restrictions.
Traded:
A tradable good that is actually traded.
Non-tradable:
A good whose real domestic cost of production together
with its international transport cost is too high to permit
export and too low to make import attractive.
Non-traded: A tradable that is not traded because of the
Non-traded:
A tradable that is not traded because of the trade policies of
the country.
In prefect market conditions, the guidelines recommend
three sources of shadow prices depending on the project’s
impact on the national economy. A project through its use
and production of resources for any given output or input
may affect the:
• Supply available to the rest of the economy
• Level of its production in the rest of the economy
• Level of imports and exports
In terms of production of an output the project may:
• Increase total consumption of in the economy
• Decrease production in other parts of the economy
• Decrease imports or increase exports.
The corollary of a project’s consumption of inputs may be:
• To decrease consumption in the rest of the economy
• To increase production within the economy
• To increase imports or decrease exports
To calculate the net economic benefit, two examples are
given.
1. Bridge Project:
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 in one year.
The government is considering construction of a bridge
over a 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. 1,00,000.
Required:
Define the social cost and benefits assuming that the
monetary figures given represent economic values.
Solution:
The social costs and benefits of bridge construction may be
defined as follows:
Costs:
1. Construction cost: Rs. 3,000,000 ( This is one-time cost)
2. Maintenance cost: Rs. 10,000 (This is an annual cost)
Benefits:
1. Value of ferries released Rs 1,00,000 (This is one-shot)
2. Savings in the cost of ferry operation: Rs 1,00,000 (annual)
3. Increase in consumer satisfaction:
This is equal to willingness to pay of 2,00,000 additional
persons who are expected to use the bridge. Since first
additional person is willing to pay Rs 3 ( the charge of the
ferry operator) and the last person is willing to pay nothing
(there is no toll for the use of the bridge) the average
willingness to pay of additional users, assuming that the
demand schedule is linear, is Rs 1.50. So willingness to pay
of 2,00 000 x Rs 1.50 = Rs 3,00,000.
River Valley Project:
The government is considering a multi-purpose river valley project
which would involve construction of a dam, a reservoir, a power house,
and several irrigation canals. The project would supply water for
irrigation, generate electricity, and provide a measure of protection
against floods.
Information available:
1. Indigenous power equipment costing Rs 200 million
2. Imported power equipment costing $ 10 million
3. 20,000 tonnes of steel produced indigenously and made available to
the project at Rs. 6000 a tonne.
4. 3,50,000 tonnes of cement produced indigenously and made available
to the project at Rs. 800 a tonne.
5. Other construction materials costing Rs. 100 million.
6. 25 million man-days of unskilled labor for which the board has
decided to pay a daily wage rate of Rs. 10.
7. Skilled labor costing Rs. 100 million.
Once commissioned, the operating and maintenance cost of the project
would be Rs. 35 million per year.
The annual benefits expected from the project would be as follows:
1. 3,00,000 acres of land will be irrigated.
2. 120 million units of electricity will be generated for domestic use.
3. Flood damages to the extent of Rs. 10 million will be saved annually.
Additional Data:
1. Power equipment produced indigenously is a tradable item whose
FOB value is $ 15 million.
2. A gift of $ 10 million, available from a foreign agency, can be used for
acquiring imported equipment. This gift, however, is not project-tied.
Hence, it is not assigned to the project, it can be used for some other
purpose.
3. The shadow price per dollar is Rs.12, though the official price is Rs.10.
4. Steel is tradable item whose FOB value is $ 400 per tonne.
5. Cement is not a tradable item. One-half of the cement required for the
project will come from additional domestic production which has a
cost of Rs. 700 per tonne; one-half of the cement required for the
project will come from diversion from other consumers who are
willing to pay, on average, Rs. 1,200 per tonne.
6. Other construction materials are non-tradable items.
The requirement of the project will be met by way of additional
production. The cost of this production will be Rs. 80 million.
7. The shadow price of unskilled labor is Rs.5 per day.
8. The compensation paid to skilled workers reflects what others are
willing to pay for their services.
9. The operating and maintenance cost of Rs. 35 million reflects
economic value as well.
10. The water levy the project control board would be Rs. 100 per day
per acre. However, the value of additional output per acre,
attributable to the water supplied by the project, will be
Rs. 400 a year.
11. The electricity tariff charged by the project control board would be
30 paise per unit. The consumer willingness to pay, however, would
be, on an average, 50 per cent more than the tariff charged.
12. The project control board is not able to collect anything for the
protection provided against floods.
Required:
Define the costs and benefits from
(i) the private (project control board’s) and
(ii) and the economic point of view.
Concept of tradability
For a good that is tradable, the international price is
a measure of its opportunity cost to the country. The inter-
national price, also referred to as the border price, gives the
‘real’ value of the good in terms of economic efficiency.
Sources of Shadow Prices
The UNIDO approach suggests three sources of
shadow pricing,depending on the impact of the project on
national economy.
i) increase or decrease the total consumption in the
economy, - consumer willingness to pay
ii) decrease or increase production in the economy,
- cost of production
iii) decrease imports or increase imports, or increase
exports or decrease exports
– foreign exchange value
is an incidental outcome of legitimate economic activity.
b) It is beyond the control of the persons who are affected
by it, for better or worse.
c) It is not traded in the market place
Since SCBA seeks to consider all costs and benefits, to
whomsoever they may accrue, external effects need to be
taken into account. However, the valuation of external
effects is difficult as they are intangible in nature. Their
value is estimated by indirect means.
Examples are: oilfield, approach road, training programs,
pollution, noise, harmful external effect of the highway etc.
Labor Inputs
When a project hires labor, it could have three
possible impacts on the economy
a) it may take labor away from other employments
In this case, the shadow price of labor is equal
to what other users of labor are willing to pay
b) it may induce the production of new workers
The cost associated with this consists of marginal
product of the worker in the previous employment- if
unemployed this would become zero, the worker on the
leisure – reservation wage, increased expenditure on food if
he is idle or partly employed, movement of workers:
cost of transport, negative impact on savings if paid market
wage and the cost of training to improve skill
c) and it may involve import of workers
A premium should be added on account of the foreign
exchange remitted by these workers from their savings.
Capital Inputs
Impact of capital investment : i) conversion into the
physical assets ii) resources are withdrawn from the
national pool of savings and hence alternative projects are
foregone. Thus shadow price of capital investment involve
two questions: 1. Value of physical assets 2. The opportunity
cost of capital ( which reflects the benefits foregone)
Foreign Exchange
The UNIDO method uses domestic currency as the
numeraire. Valuation of inputs and outputs that was
measured in border rupee has to be adjusted upward
to reflect the shadow price of foreign exchange. It is on the
basis of marginal social value as revealed by the consumer
willingness to pay for the goods that are allowed to be
imported at the margin.
4. Measurement of the impact on distribution
First measure the income gained or lost by individual groups
within the society.
Groups
 Project
 Other private business
 Government
 Workers
 Consumers
 External factors
Measure of Gain or Loss
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 in the case of physical resources or the difference
between the price paid and the value received in the case
of financial transactions.
5. Savings Impact and its Value
The UNIDO method seeks to answer the following questions:
• Given the income distribution impact of the project
what would be its effects on savings?
• What is the value of such savings to the society?
6. Income Distribution Impact
Investment proposals are considered as investments for
income redistribution and their contribution toward this
goal is considered as 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 them.
Taxes
UNIDO Guide lines are:
i) For non-traded inputs or addition to non-traded inputs
consumer goods, taxes should be included a part of the
consumer willingness to pay the marginal economic value
ii) For a project augmenting domestic production by other
producers, taxes should be excluded.
iii) For fully traded goods, taxes should be ignored.
Shadow Pricing of Specific Resources
 Tradable inputs and outputs
 Non-tradable inputs and outputs
 Externalities- beneficial or harmful
 Labor inputs
 Capital inputs
 Foreign exchange
Externality
It has the following characteristics:
a) It is not deliberately created by the project sponsor but
The guidelines of UNIDO suggest that the weights, which
essentially reflect political judgements, may be determined
by an iterative process involving interaction between the
analyst and the planners.
7. Little-Mirrlees Approach
There is considerable similarity between the UNIDO and
the L-M approach. Both approaches call for:
1. Calculating accounting (shadow) prices particularly for
foreign exchange savings and unskilled labor
2. Considering the factor equity
3. Use of DCF analysis
Despite this, 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
in different stages. The L-M approach, however, tends to
view these considerations together.
8. SCBA by Financial Institutions
The financial institutions follow essentially a similar
approach which is simplified version of the L-M approach.
IDBI in its economic appraisal of industrial projects,
considers three aspects:
 Economic rate of return
It has two aspects viz.
iii) Find out social costs associated with the initial outlay
iv) Convert financial cost into social costs
 Effective Rate of Protection (ERP)
ERP=Value added at domestic prices –Value added at world prices
Value added at world prices
 Domestic Resources Cost(DRC)
It reflects the domestic cost incurred per unit of
foreign exchange saved or earned. The formula used is as
under:
DRC = A +B + C x Exchange rate
P – ( Q+R+S+T)
A = annual charge on domestic capital calculated at 10%
B = annual depreciation on domestic capital assets at 8%
C = cost of domestically procured operating inputs
P = sales realization at international prices
Q = annual charge on imported capital assets at 10%
R = annual depreciation on imported capital assets at 8%
S= annual cost of imported inputs
T = annual cost of domestically procured, tradable inputs.
Note: taxes,duties and subsidies are excluded
Example:
The domestic prices and world prices of the inputs and
outputs of a project in a normal year are given below.
Calculate the Effective Rate of Protection (ERP)
(Rs. in million)
Domestic prices World prices
Inputs
• Tradable Inputs
Raw materials 300 250
Consumable stores 50 30
• Non-tradable Inputs
Power, fuel, and water 20
Repairs and maintenance 15
Administrative and overheads 30
Selling expenses 25
90 90
• Total input Costs 440 370
• Sales Realization 500 400
• Value added 60 30

ERP = (60 – 30)/ 30 = 1 (or 100%)


• It may be emphasized that when the value added at
domestic prices is the same as the vale added at world
prices, the ERP is zero. In such a case, it implies that the
project does not enjoy any protection from international
competition.
• When the value added at domestic prices is higher than
added value at world prices, as it often happens, the ERP
takes a positive value.
• Clearly, the higher the value of ERP, the higher the implied
protection enjoyed by the project.
• It is generally agreed that the extent of protection given to
a project should not exceed 30 percent.

Note: Tariffs, import restrictions, and subsidies are used to


encourage domestic industries and protect against
international competition. The extent to which a project
is sheltered is measured by the Effective Rate of
Protection (ERP)