1.

Purpose of economic analysis

Selection of alternatives
Identification of winners and losers
Fiscal impact
Environmental impact

1
1. SELECTION OF ALTERNATIVES

The main purpose of economic analysis is to help design and select projects that
contribute most to the national income of a country

The project design, therefore, should be compared with various other designs involving
differences in such important aspects as the scale of the project, the choice of beneficiaries,
the types of outputs and services, the production technology, location, etc.

The project should also be compared with the alternative of not doing it at all.

When used solely, economic analysis serves only a very limited purpose and hence should
not be the only base for decision. B/S economic viability will be undermined if financial
viability is not ensured 2
2. Identification of winners and losers
o A good project contributes to the country’s economic output it has the potential to make
everyone better off.

o Nevertheless, normally not everyone benefits, and someone may lose.

o Identifying those who will gain, those who will pay and those who will lose gives the
analyst insight into the incentives that various stake holders have to see that the project is
implemented as deigned.

3
 3. Fiscal impact
• How and to what extent will the costs of the project be recovered from its beneficiaries?

• What changes in public expenditures and revenues will be attributable to the project?

• What will be the net effect for the government?

4. Environmental impact
o In economic analysis, the externalities of a project on the environment should be
considered and, if possible, quantified and assigned a monetary value.

4
 2. Numeraire
o One of the important aspects of economic pricing is the determination of the numeraire, the

unit of account in which the value of inputs or outputs is expressed.

o The choice of currency and price level in which to conduct the analysis must be decided

first.

o Financial analysis is usually conducted in the currency of the country undertaking the

project and at the prevailing market prices.

o Economic analysis can be conducted in domestic with domestic market price or foreign
5

currency with border price

o Financial analysis is generally done in domestic currency at the domestic price level, it is
most convenient to do the economic analysis in the same unit of account.

6
6.3. VALUATION AND SHADOW PRICES
 THE VALUE OF INPUTS USED UP (COSTS) AND OUTPUTS PRODUCED (BENEFITS) OF A
PROJECT DEPEND ON
• VALUE JUDGMENTS BY GOVERNMENT, AS WELL AS
• ON TECHNICAL AND BEHAVIORAL PARAMETERS AND
• ON THE RESOURCE AND POLICY CONSTRAINTS.
• VALUE JUDGMENTS BY THE GOVERNMENT DETERMINE THE WEIGHT TO BE GIVEN
• TO FUTURE CONSUMPTION RELATIVE TO PRESENT CONSUMPTION: THAT IS,
TO GROWTH AS AGAINST PRESENT CONSUMPTION,
• TO BENEFITS FOR DIFFERENT CLASSES OF INCOME RECIPIENTS OR
DIFFERENT REGIONS; AND
7

• TO FUTURE EMPLOYMENT RELATIVE TO PRESENT EMPLOYMENT.

• THEREFORE, SHADOW OR EFFICIENCY OR ECONOMIC PRICES CAN BE DEFINED AS

• THE VALUE OF THE CONTRIBUTION TO THE COUNTRY’S BASIC SOCIOECONOMIC OBJECTIVES

MADE BY ANY MARGINAL CHANGE IN THE AVAILABILITY OF COMMODITIES OR FACTORS OF
PRODUCTION.

8
 6.4. ECONOMIC AND SOCIAL COST BENEFIT ANALYSIS
• A PROJECT WILL BE PROFITABLE TO SOCIETY:
• IF THE ECONOMIC/ SOCIAL BENEFITS OF THE PROJECT EXCEED THE ECONOMIC/ SOCIAL COSTS

• OR IF THE NET PRESENT VALUE OF THE PROJECT TO SOCIETY IS GREATER THAN ZERO.

9
6.5. APPROACHES OF MEASURING ECONOMIC COSTS & BENEFITS OF A
PROJECT
 THERE IS CONCEPTUAL DIFFERENCE BETWEEN SOCIAL COSTS -
BENEFITS AND ECONOMIC COST - BENEFIT ANALYSIS.
 THE RESULTS OF SOCIAL COST-BENEFIT ANALYSIS MAY DIVERGE FROM
THE RESULTS OF ECONOMIC COST-BENEFIT ANALYSIS.

• ECONOMIC COSTS AND BENEFITS WHEN THEY ARE ADJUSTED TO

CONSIDER OTHER OBJECTIVES OF SOCIETY AS DISTRIBUTIONAL
CONSEQUENCES & OTHER OBJECTIVES, THEY BECOME SOCIAL COSTS &
10

BENEFITS OF A PROJECT.
• IF THE MARKET PRICES ARE ADJUSTED ONLY FOR MARKET
DISTORTIONS OF VARIOUS KINDS; DIRECT TRANSFER PAYMENTS &
EXTERNALITIES, IT IS SIMPLY ECONOMIC COST-BENEFIT ANALYSIS.

• HENCE, ECONOMIC COST BENEFIT ANALYSIS LIMITS ITSELF ONLY

TO THE ANALYSIS OF EFFECTS OF A PROJECT ON REAL NATIONAL
INCOME OF THE COUNTRY,

• SOME ANALYSTS SIMPLY ADJUST FINANCIAL COSTS & BENEFITS

INTO EFFICIENCY PRICES AND LEAVE OTHER SOCIAL ASPECTS FOR
SUBJECTIVE JUDGMENTS. 11
 6.5.1. UNIDO APPROACH
IN THIS METHOD SHADOW EXCHANGE RATE (SER) IS USED
TO MADE ADJUSTMENT FOR DIVERGENCE BETWEEN MARKET
PRICES AND ECONOMIC VALUES, AND ALSO
TO MAKE COMPARABLE DOMESTIC AND FOREIGN RESOURCES

• IN THIS METHOD, IF COMMODITIES ARE TRADED,

• FIRST ALL THESE TRADED GOODS WILL BE ADJUSTED FOR ANY
DISTORTIONS IN THE DOMESTIC MARKETS.
• AFTER THIS ADJUSTMENT IS MADE THE ADJUSTED DOMESTIC
PRICE WILL BE MULTIPLIED BY SER TO MAKE DOMESTIC 12

RESOURCES BE COMPARABLE WITH FOREIGN RESOURCES.

 THE EASIEST WAY FOR ADJUSTING DOMESTIC MARKET DISTORTIONS IS
 TO USE BORDER PRICES AND THEN MULTIPLY THIS BORDER PRICE EXPRESSED IN FOREIGN
CURRENCY BY SER TO ARRIVE AT ECONOMIC BORDER PRICES.

 BUT, IF THE COMMODITIES ARE NON-TRADED, AND IF THE MARKET PRICES ARE GOOD
ESTIMATES OF OPPORTUNITY COST OR WILLINGNESS TO PAY,

 WE DIRECTLY TAKE THE MARKET PRICE AS ECONOMIC VALUE

OF THE ITEM

13
BUT IF THE PRICES OF NON-TRADED ITEMS (GOODS AND SERVICES OR
FACTORS OF PRODUCTION) ARE DISTORTED,

• WE WILL ADJUST THE MARKET PRICE TO ELIMINATE DISTORTIONS AND

THEN USE THESE ESTIMATES OF OPPORTUNITY COST AS THE SHADOW
PRICE TO BE ENTERED IN THE ECONOMIC ANALYSIS.
• EXAMPLE: SUPPOSE WE HAVE A PROJECT PRODUCING EXPORT ITEM
THAT USES BOTH FOREIGN & DOMESTIC INPUTS.
• THE NET BENEFIT (IGNORING DISCOUNTING) WOULD BE ESTIMATED
AS:
14

• NET BENEFIT = SER(X - M) - D

 • WHERE
• X - BORDER PRICE OF EXPORTS IN FOREIGN CURRENCY

• M - BORDER PRICE OF IMPORTED INPUTS IN FOREIGN CURRENCY

• D - ADJUSTED (ECONOMIC) VALUES OF DOMESTIC INPUTS IN DOMESTIC CURRENCY

• SER - IS THE SHADOW EXCHANGE RATE (ASSUMING THE OFFICIAL EXCHANGE RATE DOES
NOT ACCURATELY REFLECT THE TRUE VALUE OF FOREIGN CURRENCIES TO THE ECONOMY).

15
SHADOW EXCHANGE RATE

THE NEED TO DETERMINE THE FOREIGN EXCHANGE PREMIUM ARISES BECAUSE IN MANY
COUNTRIES, AS A RESULT OF NATIONAL TRADE POLICIES (INCLUDING TARIFFS ON IMPORTED
GOODS & SUBSIDIES ON EXPORTS), PEOPLE PAY A PREMIUM.

• THIS PREMIUM IS NOT ADEQUATELY REFLECTED WHEN THE PRICE OF TRADED GOODS ARE
CONVERTED TO DOMESTIC CURRENCY EQUIVALENT AT THE OFFICIAL EXCHANGE RATE.

16
• THE PREMIUM, THUS, REPRESENTS THE ADDITIONAL AMOUNT THAT USERS OF TRADED
GOODS ARE WILLING TO PAY TO OBTAIN ONE MORE UNIT OF TRADED GOODS.

Pd
SER 
Pw

Where Pd - domestic price

Pw - world price in foreign currency
17
 TO DERIVE AN AVERAGE AND REPRESENTATIVE ESTIMATES OF SER THAT CAN BE
APPLIED ACROSS ALL TRADED GOODS, WE NEED TO TAKE THE WEIGHTED MEAN OF
RELATIVE VALUE OF ALL IMPORTED & EXPORTED GOODS. THUS:

n
 Pdi 
SER f i  
i1  Pwi 
fi -the weight of the ith good

18
 THE WEIGHTS (FI) ARE A FUNCTION OF THE QUANTITIES IMPORTED AND EXPORTED
AND OF THE ELASTICITIES OF DEMAND FOR THE VARIOUS IMPORTS AND THE
ELASTICITIES OF SUPPLY FOR THE VARIOUS EXPORTS.

19
Where
f im
- is weight of the ith import good
PEDI - ISx PRICE ELASTICITIES OF DEMAND OF THE ITH IMPORT
fi -is weight of the i export good
th

PESI - IS PRICE ELASTICITIES OF SUPPLY OF THE ITH EXPORT

QDI - IS QUANTITY IMPORTED OF THE ITH GOOD

QSI - IS QUANTITY EXPORTED OF THE ITH GOOD

20
6.5.2. LITTLE-MIRRLEES APPROACH(BORDER PRICE)
• IT WAS THOUGHT THAT IF A PROJECT WAS
WORLD
ANALYZED
PRICES,
ATTHIS WOULD GIVE AN
INDICATION
 FIRST OF WHETHER IT COULD SURVIVE IN THE LONG TERM IN THE FACE OF
INTERNATIONAL COMPETITION, AND

 SECONDLY OF WHETHER ITS OUTPUT COULD BE OBTAINED MORE CHEAPLY FROM

INTERNATIONAL SOURCES.

21
• IF WORLD PRICES ARE USED, THE ECONOMIC PRICE AT WHICH TO VALUE A PROJECT’S
OUTPUT IS

ITS EXPORT PRICE IF IT ADDS TO EXPORTS; OR

ITS IMPORT PRICE IF DOMESTIC PRODUCTION LEADS

TO A SAVING IN IMPORTS (IMPORT SUBSTITUTION).
• SIMILARLY, ON THE COST
WHICH
SIDE,
TOTHE
VALUE
PRICE
A PROJECT
AT INPUT IS:

 ITS IMPORT PRICE IF IT HAS TO BE IMPORTED, OR

 EXPORT PRICE IF GREATER USE LEADS TO A
REDUCTION IN EXPORTS. 22
 THE ABOVE ADJUSTMENT APPLIES FOR
• TRADED GOODS (IMPORTED OR EXPORTED GOODS).
 BUT IF THE GOODS OR INPUTS IN QUESTION ARE NON-
TRADED GOODS,
• THE ANALYST NEEDS TO USE CONVERSION FACTOR TO TRANSLATE DOMESTIC PRICES
INTO THEIR BORDER PRICE EQUIVALENT.

• A CONVERSATION FACTOR (CF) IS THE RATIO OF THE ECONOMIC (SHADOW) PRICE TO

THE MARKET PRICE, THAT IS:

23
 SO THE ECONOMIC PRICE FOR A NON-TRADED GOOD IS

 ITS MARKET PRICE MULTIPLIED BY THE CONVERSION

FACTOR.
HOW ARE CONVERSION FACTORS DERIVED?

• THE TRUE COST OF ANY GOOD IS ITS MARGINAL COST TO SOCIETY.

• IN PRINCIPLE, TO FIND THE WORLD PRICE OF NON- TRADED GOODS, EACH GOOD
COULD BE DECOMPOSED INTO ITS TRADED AND NON-TRADED COMPONENTS IN
SUCCESSIVE ROUNDS

24
• THE DERIVATION IS AS FOLLOWS:

SCF .Pd  Pw .OER

Pw OER 
SCF 
• Pd PRICE IN DOMESTIC CURRENCY
WHERE PD = DOMESTIC
•PW = WORLD PRICE IN FOREIGN CURRENCY

• OER = OFFICIAL EXCHANGE RATE

• SCF = STANDARD CONVERSION FACTOR

25
 1
SCF 
Pd
Pw OER 
IS THE SHADOW EXCHANGE RATE I.E., THE PRICE OF GOODS IN DOMESTIC CURRENCY
RELATIVE
P TO THEIR WORLD PRICES
d
Pw

1 1
• SCF  SHADOW PRICE
IS THE  OF FOREIGN EXCHANGE (PF)
SER PF
OER
SER
OER

26
• WHERE FI - WEIGHTS FOR THE ITH COMMODITY

• PDI- DOMESTIC PRICE OF THE ITH COMMODITY IN DOMESTIC CURRENCY

• PWI- WORLD PRICE OF THE ITH COMMODITY INFOREIGN CURRENCY

• PF- SHADOW PRICE OF FOREIGN EXCHANGE

27
• TAKING THE FOLLOWING EXAMPLE CAN SUMMARIZE
LITTLE-MIRRLEES APPROACH OF ADJUSTING DOMESTIC
PRICES INTO ECONOMIC PRICES.
• A PROJECT THAT PRODUCES EXPORT GOODS CAN BE ASSESSED AS FOLLOWS:

• NET BENEFIT= OER (X-M) - SCF.D

• WHERE - OER- OFFICIAL EXCHANGE RATE

X- EXPORTED GOODS IN FOREIGN CURRENCY

M- IMPORTED GOODS IN FOREIGN CURRENCY

SCF- STANDARD CONVERSATION FACTOR

28

D- PRICE OF NON-TRADED GOODS IN DOMESTIC

CURRENCY
 TO SUMMARIZE, AS LONG AS SCF IS THE RATIO OF OER TO SER, THE TWO

APPROACHES - UNIDO AND LITTLE MIRRLESS - DIFFER :

• ONLY TO THE EXTENT THAT SER IS

DIFFERENT FROM THE ACTUAL

EXCHANGE RATE.

29
6.7. VALUATION OF NON-TRADED GOODS
• NON-TRADABLE ITEMS ARE THOSE WHICH ARE NOT TRADED
INTERNATIONALLY.
• THEY INCLUDE ITEMS SUCH AS:

SERVICES WHERE THE DEMANDER AND PRODUCER

MUST BE IN THE SAME LOCATION, AND

COMMODITIES WHICH HAVE LOW VALUE RELATIVE

TO EITHER THEIR WEIGHT OR VOLUME.
• IN SUCH CASES THE TRANSPORTATION CHARGES PREVENT
PRODUCERS FROM PROFITABLY 30

EXPORTING THEIR GOODS.

• TYPICALLY, NON-TRADABLE GOODS INCLUDE SUCH ITEMS AS
 WATER SUPPLY, ALL PUBLIC SERVICES, REAL ESTATE, CONSTRUCTION, LOCAL
TRANSPORTATION;

 GOODS WITH VERY HIGH TRANSPORTATION COSTS SUCH AS GRAVEL; AND COMMODITIES
PRODUCED TO MEET SPECIAL CUSTOMS OR CONDITIONS OF THE COUNTRY.
• IF DETERMINATION OF PRICE TAKES PLACE IN THE WORLD MARKET, THE GOOD
SHOULD TRADABLE.
BE CONSIDERED
• IF THE SETTING OF THE PRICE TAKES PLACE BY SUPPLY AND DEMAND IN THE
LOCAL MARKET, THE GOOD SHOULD BE CONSIDERED NON-TRADABLE.

31
 VALUATION OF NON TRADED GOODS WILL MAINLY DEPEND ON SUCH FACTORS
AS:
 QUANTITY OF INPUT DEMANDED AND OUTPUT SUPPLIED
 ELASTICITY OF DEMAND AND SUPPLY
 MARKET IMPERFECTIONS;
 GOVERNMENT INTERVENTION OF DIFFERENT KINDS;
 TAXES AND SUBSIDIES THAT ARE TARGETED TO COMPENSATE
EXTERNAL COSTS
(OR BENEFITS) AND
 OTHER INDIRECT TAXES, SUBSIDIES AND PRICE CONTROLS TARGETEDFOR SOME
OTHER PURPOSES.

32
 6.8. VALUING OUTPUT USING MARKET PRICES
• THE WILLINGNESS TO PAY FOR THE OUTPUT OF THE PROJECT MAY BE
MEASURED BY THE MARKET PRICE PROVIDED THE FOLLOWING
CONDITIONS ARE SATISFIED:
1. THERE IS COMPETITIVE BUYING IN THE MARKET PLACE

2. THE ADDITIONAL SUPPLY CONTRIBUTED BY THE PROJECT

LEAVES THE
MARKET PRICE UNCHANGED.

 HOWEVER, THESE CONDITIONS WOULD NOT IN MOST CASES BE

SATISFIED AND USING MARKET PRICES TO VALUE PROJECT OUTPUTS
WOULD BE BIASED.
33
 TA X E S , E X T E R N A L I T I E S A N D O T H E R S TA N D A R D M A R K E T D I S T O RT I O N S M U S T B E
A C C O U N T E D F O R C O R R E C T LY.
 THERE ARE THREE EFFECTS WHEN A PROJECT SUPPLIES
`ITS
` OUTPUT TO THE MARKET:
1. THE MARKET PRICE OF THE OUTPUT MAY FALL AS A RESULT OF THE INCREASE IN
SUPPLY;
2. OTHER PRIVATE PRODUCERS MAY WIND UP SUPPLYING LESS OF IT BECAUSE OF
THE REDUCED PRICE; AND
3. CONSUMERS OF THE OUTPUT MAY PURCHASEOF
MORE
IT IF PRICE DECLINES.

34
6.9 VALUING NON-TRADED INPUTS
• THERE ARE THREE IMPLICATIONS OF USING INPUTS IN A PROJECT.

 FIRST, THE MARKET PRICE OF THE INPUT MAY RISE AS A RESULT OF THE INCREASE IN
DEMAND FOR THAT INPUT.
 SECOND, OTHER CONSUMERS OF THE INPUT MAY WIND UP USING LESS OF IT
BECAUSE THE PROJECT HAS TAKEN SOME OF THE INPUT OUT OF THE MARKET.
 THIRD, PRODUCERS OF THE INPUT MAY MAKE MORE OF IT TO COVER THE
ADDITIONAL DEMAND OF THE PROJECT1

35
• THE RELATIVE SIZES OF DECREASED PRIVATE CONSUMPTION AND
INCREASED PRODUCTION WILL DEPEND ON THE RELATIVE
ELASTICITIES OF SUPPLY AND DEMAND.
• BOTH THE DECREASE IN PRIVATE CONSUMPTION AND THE INCREASE
IN PRODUCTION OF THE INPUT ARE COSTS OF THEPROJECT.
• THE DECREASE IN PRIVATE CONSUMPTION IS A COST BECAUSE
INDIVIDUALS WILL BE CONSUMING LESS OF A GOOD OR SERVICE
THEY DESIRE.
• THE INCREASE IN PRODUCTION IS A COST BECAUSE PRODUCTIVE
INPUTS WILL BE SHIFTED FROM OTHER ACTIVITIES TOWARD
36

INCREASED PRODUCTION OF THIS INPUT.

6.10 TRADABLE BUT NON TRADED ITEMS

• THIS CAN LEAD TO DIFFICULT CHOICE WHEN THE ANALYST

MUST EVALUATE THE REAL EFFECTS ON RESOURCES OF A

PROJECT THAT INVOLVES ITEMS THAT COULD BE TRADED BUT

PROBABLY WILL NOT BE BECAUSE OF GOVERNMENT

REGULATION.

• THESE ITEMS, WHICH ARE ''TRADABLE BUT NON- TRADED'' ACROSS

37

NATIONAL BOUNDARIES ARE VALUED AS NON TRADED.

 THUS, THE PROJECT ANALYSIS MUST BE CARRIED OUT WITHIN THE FRAMEWORK OF
ECONOMIC POLICIES SET BY THE GOVERNMENT.

THE PROJECT ANALYST MUST MAKE THE BEST

JUDGMENT ABOUT
 WHAT THOSE POLICIES ARE AND W ILL BE, NOT JUST WHAT THEY OUGHT TO BE ,
AND W ORK THE ECONOMIC ANALYSIS ACCORDINGLY.

 THEIR DOMESTIC PRICE MAY WELL RISE HIGH ABOVE THE PREVAILING
PRICE ON THE WORLD MARKET.

38
• IF THE QUESTION WERE TO EVALUATE WHETHER THESE
ITEMS SHOULD BE TRADED FREELY OR NOT,

 THE ANALYST WOULD TREAT THESE ITEMS AS TRADED

ITEMS AND WOULD EVALUATE THE RELATIVE
ADVANTAGE OF THE TRADE POLICY.
 OF COURSE, IF THE PROJECT ANALYST EXPECTS THAT THERE
WILL BE POLICY CHANGES IN THE FUTURE WITH RESPECT TO
THE ITEM, HE CAN TREAT IT AS TRADED GOOD AND USE
BORDER PRICE WITH APPROPRIATE ADJUSTMENT TO PARITY 39

PRICE.
6.11. VALUING EXTERNALITIES
• THE FINANCIAL COSTS OF THE PROJECT WILL
NOT INCLUDE THE COSTS OF THE EXTERNALITY
• HENCE, AN EVALUATION OF THE PROJECT
BASED ON PRIVATE MARGINAL COST (PMC) WILL
 UNDERSTATE THE SOCIAL COSTS OF THE PROJECT &
 OVERSTATES ITS NET BENEFITS.

• IN PRINCIPLE, ALL WE NEED TO DO TO

ACCOUNT FOR THE EXTERNALITY IS
 TO WORK WITH SOCIAL RATHER THAN PRIVATE COSTS AND
40
BENEFITS.
 NEVERTHELESS, AN ATTEMPT SHOULD ALWAYS BE MADE TO
IDENTIFY THEM AND IF THEY APPEAR SIGNIFICANT, TO
MEASURE THEM.

• WHEN EXTERNALITIES CANNOT BE QUANTIFIED THEY

SHOULD BE DISCUSSED IN QUALITATIVE TERMS.

 IN SOME CASES IT IS IMPORTANT TO

“INTERNALIZE” EXTERNALITIES BY
 CONSIDERING A PACKAGE OF CLOSELY RELATED
ACTIVITIES AS ONE PROJECT - THAT IS, TO DRAW THE
“PROJECT BOUNDARY” TO INCLUDE THEM.
41
 DRAWING THE “PROJECT BOUNDARY” TO
INTERNALIZE EXTERNALITY CAN BE DONE IN TWO
WAYS:
1. THE PROJECT CAN ADOPT A TECHNOLOGY SUCH AS
POLLUTION ABATEMENT TECHNOLOGY THAT WILL
REDUCE OR AVOIDED EXTERNALITIES AND
2. THE PROJECT THAT IS CREATING EXTERNAL DAMAGE
CAN BE TAXED SO AS TO COMPENSATE AFFECTED 42

GROUPS IN THE SOCIETY.

 6.11.1 METHODS OF VALUING ENVIRONMENTAL EXTERNALITIES:

METHODS
• SEVERAL METHODS ARE AVAILABLE TO VALUE ENVIRONMENTAL
EXTERNALITIES.
• SOMETIMES A PROJECT USES RESOURCES WITHOUT PAYING FOR THEM.
• FOR EXAMPLE A FACTORY MAY EMIT SOOT THAT DIRTIES
SURROUNDING BUILDINGS, INCREASING THEIR MAINTENANCE COSTS.

 THE HIGHER MAINTENANCE COSTS ARE DIRECT RESULT OF THE

FACTORY’S USE OF A RESOURCE, AIR, THAT FROM ITS POINTS OF VIEW IS

FREE BUT THAT HAS A COST TO SOCIETY.

43
• LIKEWISE, A NEW IRRIGATION PROJECT MAY LEAD TO REDUCED FISH
CATCH OR THE SPREAD OF A DISEASE.

 THIS PROJECT MAKES CERTAIN GROUPS BETTER OFF BUT THE

NATURE OF THE BENEFITS IS SUCH THAT THE PROJECT ENTITY
CANNOT EXTRACT A MONETARY PAYMENT FROM THEM.

 “EXTERNALITIES” ARE REAL COSTS AND BENEFITS ATTRIBUTABLE TO

THE PROJECT AND SHOULD BE INCLUDED IN THE ECONOMIC ANALYSIS
AS PROJECT COSTS OR AS PROJECT BENEFITS.
 THE MAIN PROBLEM WITH EXTERNALITIES IS MEASURING THEM
ALTHOUGH IT IS EASY TO IDENTIFY EXTERNALITY.
44

 IT IS NOT EASY TO QUANTIFY AND ASSIGN MONETARY VALUE TO THEM

 BEFORE CHOOSING AN APPROPRIATE METHOD, IT IS IMPORTANT TO MAKE DECISION
ON TWO POINTS –

THE BOUNDARY AND

TIME HORIZON TO WHICH THE ANALYSIS WILL BE

DONE.
 WHENEVER WE ASSESS THE INTERNAL BENEFITS & COSTS OF A PROJECT, THE
BOUNDARIES ARE CLEAR:

 IF THE BENEFITS ACCRUE TO THE PROJECT ENTITY OR IF THE COSTS ARE

BORN BY THE PROJECT ENTITY, THEY ENTER INTO THE ANALYSIS.
45
•THE SECOND DECISION CONCERNS THE TIME
HORIZON.
LIKE THE PROJECTS PHYSICAL BOUNDARIES, ITS
TIME HORIZON ALSO BECOMES BLURRED WHEN
WE FROM FINANCIAL TO ECONOMICS ANALYSIS.
• A PROJECT’S ENVIRONMENTAL IMPACT MAY
NOT LAST AS LONG AS THE PROJECT OR IT
46

MAY OUTLIVE IT.

  IF THE ENVIRONMENTAL IMPACT LASTS LESS TIME THAN THE EXPECTED
ECONOMIC LIFE OF THE PROJECT,

 THE EFFECTS CAN BE INCLUDED IN THE

STANDARD ECONOMIC ANALYSIS.
• AFTER BOUNDARY AND TIME DECISIONS ARE MADE,

 THE NEXT STEP IS TO CHOOSE AN APPROPRIATE METHOD OF VALUATION OF

EXTERNALITIES.

47
METHODS FOR MEASURING ENVIRONMENT RESOURCE VALUES
ARE:

1 DIRECT METHODS:
.

 MARKET PRICE
 CONTINGENT VALUATION

2. INDIRECT METHODS:
 TRAVEL COST
 HEDONIC PROPERTY VALUE
 HEDONIC WAGE VALUES
 AVOIDANT EXPENDITURES
 CONTINGENT RANKING

48
 1. DIRECT METHODS:

a) MARKET PRICE (DIRECT) - HAVE

IF THEACOSTS
MARKETOR PRICE
BENEFITS
WE DIRECTLY TAKE THE MARKET
PRICE EXCEPT IN THIS CASE WE MAY HAVE TO ADJUST FOR ANY DIVERGENCE
BETWEEN THE MARKET AND ECONOMIC PRICES.

b) CONTINGENT VALUATION - ALSO CALLED WILLINGNESS- TO-PAY.

 CONTINGENT VALUATION APPROACH ASKS RESPONDENTS

• WHAT VALUE THEY WOULD PLACE ONOR
ANBENEFIT.
EXTERNAL COST

49
• MORE COMPLICATED VERSIONS ASK WHETHER THE RESPONDENT WOULD PAY $X TO
PREVENT
COST OR THE
OBTAINING
EXTERNAL
THE BENEFITS.

• THE ANSWER MAY REVEAL FAIR ESTIMATE OF EXTERNAL COSTS AND BENEFITS IF THE
SURVEY IS MANAGED CAREFULLY.

• CONTINGENT VALUATION METHOD HAVE THE FOLLOWING WEAKNESSES ESPECIALLY IF

THE RESPONDENTS ARE
USER
PASSIVE
OR NON USERS.

1. THE TENDENCY THAT THE WILLINGNESS TO PAY ESTIMATES TO

SEEM UNREASONABLY LARGE;

50
2. THE DIFFICULTY IN ASSURING THE RESPONDENTS HAVE UNDERSTOOD OR ABSORBED
THE ISSUES IN THE SURVEY; AND

• THE DIFFICULTY IN ASSURING THAT RESPONDENTS ARE RESPONDING TO THE SPECIFIC

ISSUE IN THE SURVEY RATHER THAN REFLECTING WARM FEELING ABOUT PUBLIC-
SPIRITEDNESS OR THE 'WARM-GLOW' OF GIVING.
 YET, IF THE SURVEY IS CAREFULLY MANAGED THE CONTINGENT VALUATION TECHNIQUE
CAN GIVE A GOOD ESTIMATE OF THESE COSTS & BENEFITS.

51
2. INDIRECT OBSERVABLE METHODS –
 THESE ARE BASED ON OBSERVABLE BEHAVIOR
BECAUSE THEY INVOLVE ACTUAL (AS OPPOSED TO
HYPOTHETICAL) BEHAVIOR, AND
 THEY ARE INDIRECT BECAUSE THEY INFER A VALUE
RATHER THAN ESTIMATE IT DIRECTLY.
a) TRAVEL COST METHODS:

• THIS MAY INFER THE VALUE OF A RECREATIONAL

RESOURCE (SUCH AS A SPORT, FISHERY, A PARK, A
WATERFALL, OR A WILD LIFE PRESERVE WHERE VISITOR S
HUNT WITH A CAMERA) BY USING INFORMATION ON HOW 52

MUCH THE VISITORS SPENT IN GETTING TO THE SITE TO

 B) HEDONIC PROPERTY VALUE:
 DECOMPOSE THE VARIOUS ATTRIBUTES OF VALUE IN PROPERTY INTO
THEIR COMPONENT PARTS.
• FOR EXAMPLE, IT IS POSSIBLE TO DISCOVER THAT ALL OTHER THINGS BEING EQUAL
PROPERTY VALUES ARE LOWER IN POLLUTED NEIGHBORHOODS THAN IN CLEAN
NEIGHBORHOODS.
•HEDONIC PROPERTY VALUE AND HEDONIC WAGES APPROACHES SHOW THE ENVIRONMENTAL
COMPONENT OF VALUE IN A RELATED MARKET.

• THIS ALLOWS THE ANALYST TO SEPARATE OUT THE RELATIONSHIP BETWEEN PROPERTY
VALUES AND POLLUTION.

53
 THIS RELATIONSHIP CAN THEN BE USED TO PRODUCE A WILLINGNESS TO PAY
FOR POLLUTION REDUCTION.

C) HEDONIC WAGES APPROACHES:

 THESE ARE SIMILAR WITH THE ABOVE EXCEPT THAT THEY ATTEMPT TO
ISOLATE THE COMPONENT OF WAGES, WHICH SERVES TO COMPENSATE
WORKERS
RISKYIN
OCCUPATIONS FOR TAKING ON THE RISK.
•IT IS WELL KNOWN THAT WORKERS IN HIGH-RISK OCCUPATIONS DEMAND HIGHER WAGES IN
ORDER TO INDUCE THEM TO UNDERTAKE THE RISKS

54
 d)AVOIDANCE EXPENDITURES :
• THESE ARE EXPENDITURES THAT ARE DESIGNED TO REDUCE
THE DAMAGE CAUSED BY
POLLUTION BY TAKING SOME KIND OF AVERTING OR DEFENSIVE ACTION.
• AN EXAMPLE WOULD BE
 TO INSTALL INDOOR AIR PURIFIERS IN RESPONSE TO POLLUTED AIR OR
 TO RELY ON BOTTLED WATER AS A RESPONSE TO THE POLLUTION OF LOCAL DRINKING
WATER SUPPLIES,
 BUYING ‘TENTS’ TO PROTECT ONESELF FROM MOSQUITO CAUSING MALARIA, ETC.
 SINCE PEOPLE WOULD NOT NORMALLY SPEND MORE TO PREVENT A PROBLEM
THAN WOULD BE CAUSED BY THE PROBLEM ITSELF
• AVERTING EXPENDITURES CAN PROVIDE A LOWER BOUND ESTIMATE OF THE
DAMAGE CAUSED BY POLLUTION

55
 d)CONTINGENT RANKING:
• IN THIS METHOD RESPONDENTS ARE GIVEN A SET OF HYPOTHETICAL SITUATIONS THAT
DIFFER IN TERMS OF ENVIRONMENTAL AMENITIES (PLEASANTNESS) AVAILABLE AND
OTHER CHARACTERISTICS THE RESPONDENTS ARE PRESUMED TO CARE ABOUT,
 AND ARE ASKED TO RANK THESE SITUATIONS IN TERMS OF THEIR
DESIRABILITY.
 THESE RANKINGS CAN THEN BE COMPARED`THE
TO SEE
IMPLICIT TRADE OFFS
BETWEEN MORE OF THE ENVIRONMENTAL AMENITY AND LESS OF THE OTHER
CHARACTERISTICS
 EXAMPLE: THESE CHARACTERISTICS COULD BE AN INCREASE IN PRICE RELATED
TO THE PRODUCT OR LOSS IN SOME BENEFITS RELATED TO IT.

56
 6.11.2. VALUING HUMAN LIFE

• ONE FASCINATING PUBLIC POLICY AREA WHERE APPROACHES OF VALUING

EXTERNALITIES HAVE BEEN APPLIED IS IN THE VALUATION OF HUMAN
LIFE.

HOW IS LIFE TO BE VALUED?

• THE SIMPLE ANSWER OF COURSE IS THAT, LIFE IS PRICELESS BUT THAT

TURNS OUT TO BE NOT VERY HELPFUL.

• SINCE THE RESOURCES USED TO PREVENT LOSS OF LIFE ARE SCARCE,

CHOICES MUST BE MADE.
57
 ONE METHOD IS TO VALUE THE PROBABILITY OF DEATH RESULTING FROM A REDUCTION IN
ENVIRONMENTAL RISK OR FROM AN IMPROVEMENT OF A GIVEN SERVICE.
 • IN THIS CASE, IT IS NOT THE LIFE ITSELF THAT IS BEING VALUED BUT
RATHER
 A REDUCTION IN THE PROBABILITY THAT SOME SEGMENT IN THE POPULATION COULD BE EXPECTED TO DIE
EARLIER THAN OTHERWISE.

• EXAMPLE:

• IF PROBABILITY OF DEATH IS EXPECTED TO DECLINE FROM ONE OUT OF

100,000 TO ONE OUT OF 150,000DUE TO REDUCTION IN ENVIRONMENTAL
RISK,

 THIS IMPLIES THAT THE NUMBERS OF EXPECTED DEATHS WOULD

FALL FROM 10 TO 6.67, IF THE TOTAL POPULATION WERE ONE MILLION.

• IF EACH PERSON IS WILLING TO PAY, SAY BIRR 5, FOR THIS RISK REDUCTION,
THEN THE IMPLIED VALUE OF A LIFE IS APPROXIMATELY BIRR 1.5 MILLION. 58
 • 10-6.67=3.33 TOTAL REDUCTION IN DEATH PER MILLION PEOPLE

• EACH PERSON’S WILLINGNESS TO PAY FORREDUCTION

THIS IN DEATH IS 5
BIRR

• 5BIRR /3.33 REDUCED DEATHS=1.5 BIRR PER REDUCED DEATH WHICH IS

WILLINGNESS TO PAY FOR EACH REDUCTION IN DEATH PER PERSON

• TOTAL POPULATION PAYING 5 BIRR=1,000,000

• 1.5X1,000,000=1.5 MILLION BIRR IS THE IMPLIED VALUE OF A LIFE

 THE OTHER METHOD, ALTHOUGH NOT ECONOMICALLY SOUND, IS ''HUMAN
CAPITAL'' APPROACH THAT ESTIMATES THE PRESENT VALUE OF FUTURE
EARNING OF AN INDIVIDUAL THAT WOULD BE LOST BECAUSE OF
59

PREMATURE MORTALITY.
• THE DIFFICULTY ARISES WHEN COMPARING ESTIMATES BETWEEN COUNTRIES WITH

VERY DIFFERENT INCOME LEVELS

• ALTHOUGH MOST ECONOMISTS DO NOT FAVOR USING THIS METHOD FOR PROJECT

AND POLICY ANALYSIS PURPOSE, IT IS OFTEN USED TO ESTABLISH EX-POST COURT

SETTLEMENTS RELATED TO DEATH OF A PARTICULAR INDIVIDUAL.

 THE OTHER METHOD, AS DISCUSSED PREVIOUSLY, IS THE WAGE DIFFERENTIAL

APPROACH OR HEDONIC WAGE VALUES.

 IN THE ABSENCE OF CAREFULLY DONE NATIONAL STUDIES OF THE VALUE OF A

STATISTICAL LIFE,

 IT IS OFTEN BEST TO PRESENT MORTALITY DATA IN TERMS OF THE

NUMBER OF LIVES LOST OR SAVED RATHER THAN IN TERMS OF A DOLLAR 60

VALUE.
 CHAPTER 7

MEASURES OF PROJECT WORTH

61
• When costs and benefits have been identified,
quantified and priced (valued), the analyst is trying to
determine
 which among various projects to accept, which to reject.
• There are two methods for measuring the worthiness of
projects:

1. undiscounted & 62
• The arithmetic of these methods, and the way we interpret
the measures and their limitations, is exactly the same

 whether we are using them for financial analysis or for

economic analysis.

63
• There are two critical points important to note
1. there is no one best technique for estimating project worth;
 each has its own strength & weakness.
2. these financial and economic measures of investment worth
are only tools of decision-making,
 i.e., they are necessary conditions & are not sufficient

condition for final decision.

64
 The most used non-discounted measures of project
worth are
1. Ranking by inspection
2. Payback period
3. Return on investment

65

Here by simply looking at the investment costs and the
‘shape’ of the stream for the net value of incremental
production that one project should be accepted over another
if we must choose.

66
• The analyst can sometimes simply choose one project among
alternative projects by examining the following:
 Total cost of investment and investment period;
 The structure, & amount of costs and benefits;
 total amount of the net incremental benefit;
 The lifetime of the project, etc. 67
• If two projects have the same initial investment, and different
lifespan, the same proceeds throughout the period of the short-
lived investment, and if the long lived investment to earn
income after the end of the short-lived one, then, the long-lived
one is more desirable
 Because all things being equal, the long-lived project

continues to earn proceeds while the short- lived one has

ended.

68
•Suppose two projects have the same life period,
identical initial investment outlay, and the net proceeds
throughout the life period is identical; in this case
although the total net proceeds is identical, the project
that earns more income early than the other is more
desirable.
•The problem with Ranking by inspection
method is that the selection lacks objectivity.

69
• The payback period is the length of time from the beginning
of the project until the sum of net incremental benefits of
the project equal to total capital investment.

It is the length of time that the project requires to

recover the investment cost.

70
 • This method has two weaknesses:
1. it fails to consider the time & amount of net benefits
after the payback period.

2. it does not adequately take into account the time value of

money even in the payable periods.

71
Alternative Year Investment cost Net incremental
projects benefits
I 1 20000 -
2 2000
3 8000
4 12000
5 9000
II 1 20000 -
2 200
3 12000
4 8000
5 12000
III 1 20000 -
2 1000
3 5000
4 6000
5 8000
6 10000
7 5000
8 2000 72
• Project I & II have a payback period of 4 year.
• But project III has a payback period of 5 years.
• Thus, based on this criterion, project I & II have equal
higher rank than project III.
 Therefore, the method fails to consider the time & amount of
net incremental benefit after the payback period- project III.
 In addition, the method results equal rank for both project I
and II.

73
Yet we know by inspection that we would choose
project II over project I because more of the returns to
project II are realized earlier.

 Payback Period method is a measure of cash

recovery, not profitability
74
• Average income on cost is formed by:
 Dividing the average income by the cost of
investment or
 Dividing the average income by the book value.

75
Investment Cost ($) Average Average Ranking
income($) income on
Cost (%)
A 20,000 0 0 4
B 20,000 660 3.3 3
C 20,000 800 4 1
D 20,000 800 4 1

76
 Average income on cost has the disadvantage of not
taking into consideration the timing of the cash flow.

77
 Thisis the ratio of average income to the book value of the
assets (i.e. the value after subtracting depreciation) stated in
percentage terms.

 Thismeasure is useful and commonly used way of assessing

the performance of an individual firm.
This measure, does not take into consideration the
timing of the benefit stream.
78
• assuming strait-line deprecation for all project, average
income on book value can be calculated as follows:

79
Proje ct Average net value Annual Net Average Average
of incremental deprecat average book value income on
benefit ion income book value(%)

A 7050 5000 2250 10000 22.5

B 8000 5000 3000 10000 30.0

C 5285.7 2857.1 2428.6 10000 24.2

80
Time value of money
• Present values are better than the same values in the future and
earlier returns are better than later.
• This shows that money has time value.
• Thus, to include the time dimension in our project evaluation, we
have to use discounting methods.
81
• Discounting is essentially a technique that ‘reduces’ future
benefits and costs to their ‘present worth’.

• The rate used for discounting is called discount rate.

82
• Suppose a bank lends 1567.05 Birr for a project at 5%
interest rate.
• The project owner is supposed to repay the principal &
interest rate after 5 years.
• How much the owner will have to pay at the end of 5 years?

83
At = P(1 + r) t
At = total amount after t years
r = interest rate
t = time
P=Principal
A5 = 1567.05 (1 +
0.05)5
= 2000 Birr
84
• Suppose again a project is expected to obtain 2000
Birr after 5 years.
• Value of this money today can be calculated as:
At 2000
  1567 . 05
P 

1 r  t
1  0 . 05  5

85
• The undiscounted measures of project worth have one
serious shortfall:

 they do not take into account the difference between

the value of money today , and the same value in the
future.

86
• By contrast discounted measures of project worth are based
on the concept that” to receive some today is better than to
receive more tomorrow”
• Commonly used discounted measures are:
 Net Present Value
 Internal Rate of Return
 Benefit- Cost Ratio
 Net Benefit - Investment Ratio

87
• It is the present value of expected future net cash flows, discounted at
the costs of capital, less the initial outlay.
n

NPV   At t
t 1 1  r   I
NPV - net present value
At = net cash flow for the year t
r - cost of capital
n- life of the project
I- initial outlay 88
 •In the net present value method, the higher the
NPV, the more desirable the project is.

•
All projects that have a positive NPV are accepted and
projects that have a negative NPV are rejected.

89
 However, in ranking mutually exclusive project (if one
is chosen, the other cannot be undertaken), ranking based on
NPV depends on the dissonant rate used.

• That is if we have two mutually exclusive projects, project A and

project B - project A may be ranked first in some ranges of discount
rates but may turn out to be second in some other ranges.

90
 Discounted measure of project worth based on discounted

NPV, though it accounts the time value of money and all

flows in the lifetime of the project, it depends on the value

of discount rate (r).

91
• The internal rate of return is the rate of discount at which the total
discounted cash proceeds( benefits) expected from the project equals the
total discounted cash outlays (costs) required by investment.

 In other words, the IRR is the rate which makes NPV of the project
equal to zero

92
 n
At
I   1 r  t
T 1

I –
investment
cost
At – Net benefit for year t
r - IRR
n - Life of the project

93
 Illustration: For a project with investment cost of 1000 and net cash
flow of 200,400, 500 and 700 for four consecutive years, IRR is
formulated as
200 400 500 700
1000    
1 r  1
1 r  2
1 r  3
1  r  4

•r can be found through trial & error method.

94
• When r = 23.068 percent the value in the above
equation in the right hand side will be equal to
1000.0087 which is equal to the value in the left hand
side.

• The problem with this method is that the value of r

(IRR) can only be found by trial and error.

95
• The procedure to find r can be described as follows:
1. Select an arbitrary value of r;
2. Calculate the value of the right hand side equation with this
value of r.
3. If the RHS value is lesser than the value in the left hand,
reduce the value of r.
4. If the RHS is greater than the LHS, increase the value of r;
continue until this the RHS is very close to the LHS.
5. When the RHS is more or less equal to LHS, it is that value
of r, which is the IRR.

96
 When using the IRR, the investment criterion is
that the IRR should be greater than the discount rate.

97
• Generally, for one single project, there is a relationship b/n the
present value, the rate of return, the cost and benefits

• When the NPV is positive, then

IRR is greater than the rate of discount and the discounted
benefits are greater than the discounted costs;

98
• When NPV is equal to zero, then
 the IRR is equal to the rate of discount and discounted benefits
are equal to the discounted costs; and

• When NPV is negative, then

 the IRR is smaller than the discount rate and the discounted
benefits are smaller than the discounted costs
99
• This is the ratio obtained when the present worth of the
benefit stream is divided by the present worth of the cost
stream.

• The mathematical formula is given below.

n
Bt
 (1  r ) t
Benefit  cos t ratio  t 1
n
Ct

t 1 (1  r ) t

100
 BENEFIT-COST
Where RATIO…
Bt - are the benefits in period t
Ct - are the costs in period t
n - project life
r - discount rate

101
• The selection criterion for the benefit-cost ratio measure
of project worth is that
 the discounted benefits should exceed discounted costs i .e

benefit-cost ratio of greater than 1

102
• It is suitable and convenient for ranking projects especially
when sufficient budget is not available to implement all
projects that satisfy other criteria.

 That is, two or more projects may all have a positive NPV,
IRR that exceeds the discount rate, both financial and
economic discount rates, and a benefit-cost ratio of greater
than one.

103
 • In this case, ranking could be made using net Benefit -
investment ratio.
n
( Bt  Ct
Net benefit - investment ratio =
 (1  r ) t
t1
n

 I (1  r ) t
t 1
Where - Bt Benefits, Ct - costs, I- investment, r-discount rate, I-investment cost

104
• It is simply the present value of net benefits divided by the net
present worth of the investment.

• The formal selection criterion for the net Benefit - Investment

ratio measure of project worth is
 to accept all projects with a ratio of 1 or greater when they are

discounted with appropriate rate - in order, beginning with the

largest ratio value and preceding until available investment funds
are exhausted.

105
The above measures of project worth may give different
ranking in different measures if projects that are being
compared are different in their:
1. Cash flow structure

2. Magnitude of costs and benefits

3. Life time

106
1. Cash flow structure

Some projects may give high return in the early stage
of the project & decline thereafter & some other projects
may give lower return in the early stage & grow later in
the life of the project.
 The former will be less sensitive to changes in discount
factor as compared to the latter.
 Therefore, the ranking could be different in different
measures.
107
2. Magnitude of costs and benefits
 For some projects the costs & benefits could be large in magnitude than
other projects. in this case ranking based on NPV & IRR may not give same
result.
3. Life time
 Some projects have shorter life than others.

 Here also the ranking could be different in different measures.

108
• If a firm or government has unlimited funds, which is rare
in reality, these differences have no significant implication
in the decision.
 In such cases, projects with a positive NPV, the IRR value of

greater than opportunity cost of capital (discount rates), the

B-C ratio & Net return-investment ratio of greater than one
will all be chosen.

109
• However, if there is limited funds, as is often the case,
and if different criterion gives rise to different results,
 a decision must be made as to which criterion to use

for selection.
 Which criterion is then more appropriate to select
among such mutually exclusive projects?

110
Mutually exclusive projects
 Two projects could be mutually exclusive (implementing

one project necessarily precludes implementing another)

for two reasons:
 one, if there is no enough capital funds,
 and second, if these two projects are technically

contradicting (such as labor intensive or capital intensive

techniques)
111
 Inthis case, one can calculate the IRR on the marginal
flows and compare it against the cost of capital for the firm

112
113
THANK 114
ASSIGNMENT- THIS IS A REQUIREMENT TO
COMPLETE THE COURSE.
• PLEASE IDENTIFY ANY PROFIT ORIENTED PROJECT IDEA AND PREPARE A COMPLETE PROJECT
PROPOSAL. THE PROJECT PROPOSAL SHOULD INCORPORATE ALL ASPECTS OF PROJECT
PREPARATION AS MUCH AS POSSIBLE.

• NB: THE LIFE OF THE PROJECT SHOULD NOT BE LESS THAN 7 YEARS AND THE PROPOSAL
SHOULD CLEARLY SHOW THE PAYBACK PERIOD, NPV, BCR AND IRR. (USE R=14)

115