Chapter Six: Economic And Social Analysis

6.1.Purpose of Economic Analysis

6.2.Economic and social cost benefit analysis
6.2.1. Shadow Pricing / Efficiency Pricing
6.2.2. Steps in Efficiency Pricing
6.3.Approaches of measuring Economic Cost-Benefit (UNIDO/LM)
6.4.Economic Export and Import Parity Price
6.5.Valuation of Non-traded Goods
6.6.Valuing Externalities
 Chapter Six: ECONOMIC AND SOCIAL ANALYSIS
 While financial analysis focuses on the project's profitability for the entity itself,
economic analysis takes a broader view, considering the project's impact on the
entire economy.

 This leads to differences in how costs and benefits are valued: financial analysis
uses market prices, while economic analysis uses "shadow prices" that reflect
society's true opportunity cost.

 These adjustments account for market imperfections and policy objectives,

potentially leading to different conclusions about the project's merits compared
to a purely financial analysis.

 Remember, a project with negative financial NPV might still be beneficial for
society (positive economic NPV), but its financial viability needs careful
consideration and potential solutions for shortfalls must be identified.
 6.1. Purpose of Economic Analysis
Selection of alternatives
The main purpose of project economic analysis is to help,
design and select projects that contribute most to the
welfare of a country.

The tool of economic analysis can help us answer various

questions about the project’s impact on
The entity undertaking the project,
On society,
On the fiscal impact and on various stakeholders, and
About the projects risks and sustainability.
Identification of winners and losers:
A good project contributes to the country’s economic output;
hence it has the potential to make everyone better off.

Nevertheless, normally not everyone benefits, and someone

may lose.

Moreover, groups that benefits from a project are not

necessarily those that incur the costs of the project.

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.
Environmental impact
A very important difference between society’s point of
view and the private point of view concerns costs (or
benefits) attributable to the project but not reflected in its
cash flows.

The effects of the project on the environment, both

negative (costs) and positive (benefits), should be taken
into account and if possible, quantified and assigned a
monetary value.
 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?
 6.2. 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 to put in another way, if the net present value of the project to
society is greater than zero.

 The question is, how should a projects economic/ social benefits and costs be measured, and
what common unit of account (or numéraire) should the benefits & costs be expressed in,
given a societies objectives &

 The fact that it has trading opportunities with the rest of the world so that it can sell and buy
outputs & inputs abroad (so that domestic & foreign goods will be made comparable).

 Broadly, there are two methods of measuring economic costs & benefits of a project:

 UNIDO approach and

 Little-Mirrlees approach.
 6.2. Economic and social cost benefit analysis
Important concept: Numéraire
 The choice of currency and price level in which to conduct the
analysis must be decided first.

 Financial analysis is usually conducted in the currency of the

country undertaking the project and at the prevailing market prices.

 Economic analysis can be conducted in domestic or foreign

currency and at domestic market price or at border price.
6.2. Economic and social cost benefit analysis
Shadow prices/efficiency price
 Shadow prices estimate the social cost or benefit of inputs and outputs,
reflecting their true value to the economy (beyond market prices).

 Setting these prices depends on government values (prioritizing future vs.

present, income distribution, etc.), technical data, and resource
constraints.

 The chosen reference point and future policy assumptions impact the
calculation.

 These prices reflect an imperfect economy (with existing distortions) and

serve to inform policy changes (not passively accept them).
6.2. Economic and social cost benefit analysis
Shadow prices/efficiency price
 Project analysis uses positive ("what is") rather than normative
("what should be") approach, unless policy changes are expected.

 Shadow prices rely on a clear definition of government's

socioeconomic goals.

 The chosen variables and adjustments depend on specific objectives

and constraints.

 While all costs and benefits should be considered, focusing on

major decision-makers is practical.
 6.2. Economic and social cost benefit analysis
Efficiency pricing, although primarily a theoretical concept, involves a several-step approach
to achieve its goal of setting prices equal to marginal social cost. These are:

1. Identify Goods and Services:

 Begin by identifying specific goods or services where inefficient pricing might occur due
to external costs or benefits not reflected in market prices. Examples include pollution from
factories, traffic congestion, or public healthcare services.

2. Quantify External Costs and Benefits:

 This involves measuring the impact of the good or service on society beyond the direct
production costs. This requires research, data analysis, and potentially complex economic
modeling to estimate factors like:

o Negative externalities: Health impacts from pollution, resource depletion, traffic congestion, etc.

o Positive externalities: Education benefits, public health improvements, technological

advancements, etc.
 6.2. Economic and social cost benefit analysis
3. Calculate Marginal Social Cost:

 Add the production cost of the good or service to the estimated total cost of negative externalities and subtract the

value of positive externalities. This results in the true societal cost per unit.

4. Implement Efficient Pricing Mechanism:

 This is the most challenging step, as various options exist with their own complexities and political considerations:

o Pigouvian taxes: Adding taxes to goods or services to reflect the cost of negative externalities (e.g., carbon tax).

o Subsidies: Providing financial incentives to encourage activities with positive externalities (e.g., renewable energy).

o Direct regulation: Government regulations requiring specific technologies or practices to achieve societal goals.

5. Monitor and Adjust:

 Implementing efficiency pricing is an ongoing process. Evaluating its effectiveness, monitoring changes in

externalities, and adjusting the pricing mechanism (taxes, subsidies, regulations) might be necessary to maintain

efficiency over time.

6.3. 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 & benefits of a project.
This depends on the method used in the analysis.
If the market prices are adjusted only for market distortions of
various kinds; direct transfer payments & externalities, it is
simply economic cost-benefit analysis.
If on the other hand this adjustment process systematically
considers other objectives as distributional aspects, it will become
social cost-benefit analysis.
 Economic costs-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 cost & benefits into
efficiency prices and leave other social aspects for subjective
judgments.
 Particularly Squire & van der Tak (1992) recommend evaluating
proposed projects first by using essentially the same efficiency
prices then by further adjusting these prices to weight them for
income distribution effects & for potential effects on further
investment of the benefits generated.
Still some others, Little and Mirrlees (1974), & UNIDO
Guidelines for project evaluation (1972a)
 Propose evaluating the project first by establishing its economic
accounts in efficiency prices then by adjusting these accounts to
weight them for income distribution and saving effects.
A. UNIDO Approach
In this method economic benefits & costs may be measured at
domestic prices using consumption as the numeraire, with
adjustment made for divergence between market prices and
economic values, and making domestic and foreign resources
comparable using shadow exchange rate (SER).
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 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 resources be comparable with
foreign resources.
 The easiest way for adjusting domestic market distortions is to use

border prices, c.i.f., for imports and f.o.b. for exports and then
multiply this border price expressed in foreign currency by SER to
arrive at economic border prices.

112
 If the commodities are non-traded, i.e. if f.o.b. prices are less
than domestic prices & domestic prices less than c.i.f. prices 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
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.
Suppose we have a project producing export item that uses both
foreign & domestic inputs.
The net benefit (ignoring discounting) would be estimated as:
Where X - border price of exports in foreign currency
M - Border price of imported goods in foreign currency
D - Adjusted (economic) values of domestic goods 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).
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.
The premium, thus, represents the additional amount that users of
traded goods, on average & throughout the economy are willing to
pay to obtain one more unit of traded goods.
The premium people are willing to pay for traded goods, then,
represent the amount that, on average traded goods is missing priced
in relation to non-traded items when the official exchange rate is
used to reconvert foreign exchange prices in to domestic values.

115
The derivation is a follows:

Where Pd - domestic price

Pw- world price in foreign currency
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:

- The weight of the ith good .

The weights (fi ) are a function of the quantities imported and exported
and of the elasticity’s of demand for the various imports and the
elasticity’s of supply for the various exports.
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 Little-Mirrlees Approach
The other method of adjusting market prices into economic prices is
the Little-Mirrlees approach (see Little & Mirrlees, 1969, 1974),
In this approach benefits and costs may be measured at world
price to reflect the true opportunity cost of outputs and inputs
using public saving measured in foreign exchange as the numéraire
(that is, converting everything into its foreign exchange equivalent).
The fact that foreign exchange is taken as a nureraire does not
mean that project accounts are necessarily expressed in foreign
currency.

117
The unit of account can remain the domestic currency, but the
values recorded are the foreign exchange equivalent that is, how
much net foreign exchange is earned.
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.
 On the cost side, the price at which to value a project input is its
import price if it has to be imported, or export price if greater use
leads to a reduction in exports.
 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. 118
A conversation factor (CF) is the ratio of the economic (shadow)
price to the market price, that is:

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.
To find the world price of non-traded goods, each good could be
decomposed into its traded and non-traded components in
successive rounds - backwards through the chain of production.

119
It is not feasible to differentiate conversion factors between all
non-traded goods and only special outputs (and inputs) are treated
this way because the procedure is difficult, time consuming and
costly.
Shortcuts are, therefore, needed that provide a reasonable
approximation.
 All the shortcuts involve some degree of averaging for a group of
non-traded items and, therefore, some degree of error if average
or standard conversion factor is applied to a particular non traded
good rather than its own specific conversion factor.
The derivation is as follows:
120
Where P d = domestic price in domestic currency
Pw= world price foreign currency
OER = official exchange rate
SCF = standard conversion factor

121
Where fi - Weights for the i th commodity
Pdi- domestic price of the i th commodity in domestic currency
Pwi- world price in foreign currency
PF- shadow price of foreign exchange
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 Present Value (NPV) = 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
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.

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6.4.Economic Export and Import Parity Price
Export Parity Price
C.i.f. at point of import (say, Canada port)
Deduct- unloading at point of import
Deduct- freight to point of import (in this case air freight)
Deduct – insurance
Equals – f.o.b. at point of export (A.A)
Convert foreign currency to domestic currency at official exchange rate
(OER) if you are using the L-M approach or shadow exchange rate (SER) if
you are using UNIDO approach
Deduct - local port charges
Deduct - local transport & marketing (if not part of project) at their economic
price and multiply it by SCF in L-M approach
 Equals export parity price at project boundary
Deduct - local storage, transport & marketing costs (if not part of
project cost) at their economic price and multiply it by SCF in L-M
approach

 Equal economic export parity price at project location (farm gate)

 A parallel computation leads to the economic import parity price.

Here the issue can be finding the price of project's output that is
intended to substitute previous imports or the project will use
imported inputs. In either case, the import parity price can be
derived as follows.
• Import Parity Price
F.o.b. price at point of export
Add-freight charges to point of import
Add-insurance charges
Add- unloading from ship to pier at port
C.i.f. Price at the harbor of importing countries
 Convert foreign currency to domestic one (multiply by OER) if
you use L-M approach and SER if you use UNIDO approach
 Add-local port charges
 Add-transport & marketing costs to relevant wholesale market at
economic price and multiply it by SCF in L-M approach
Equal price at wholesale market
 Deduct-local storage & other marketing costs at economic price and
SCF in L-M approach (if not part of project cost) -this is the
marketing margin between central market and the project site.

 If the project uses imported inputs, we have to add this cost to the
project.
Equals economic import parity price at project location
(Farm/project gate price)

 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.
6.5.Valuation of Non-traded Goods
 Any output or input whose value to the economy cannot be measured in terms
of f.o.b. or c.i.f.
 border prices should be assessed in relation to its price in the home market.
 This applies to non-traded commodities, usually those with high transport costs,
whose domestic supply prices, at the given level of local demand, are below the
c.i.f. price of imports but above the f.o.b. price of exports.
 It also applies in cases in which government policy isolates commodities from
foreign markets through import or export prohibitions or quotas.
 This price in the home market depends on local conditions of supply and
demand, including market imperfections, monopolistic pricing, for example,
affects power rates, as do import quotas on fuel imports and, less directly,
general trade policies through their impact on such factor prices as wages.
•
6.5.Valuation of Non-traded Goods

 As a result of market imperfections or indirect taxes, the marginal

value (demand price) of non- traded inputs or outputs may differ
from their marginal cost (supply price).
 The shadow price of such goods may be the demand price, the
supply price, or somewhere in between-depending on whether
project inputs or outputs affect the supply to other users, the
demand from other producers, or both.
 To accurately account for both quantity and price effects the
analyst need to assess both the demand and supply side of these
non-traded inputs used and outputs produced by the project.
6.5.Valuation of Non-traded Goods
 non-traded inputs required (demanded) and outputs produced
(supplied) by the project can be valued.
 Their valuation will mainly depend on such factors as:
 quantity of input demanded and output supplied vis-à-vis total demand and
supply;
 elasticity of demand and supply both in the short run and long run;
 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 targeted for some other
purposes.
6.6.Valuing Externalities
 Project analysis focusing only on direct costs and benefits to the
project itself misses the bigger picture.
 Externalities, positive or negative impacts on society beyond the
project's immediate sphere, need to be considered.
 While easily identifiable externalities can be incorporated with
adjustments, accurately measuring their monetary value is often
difficult.
6.6.Valuing Externalities
 Still, efforts should be made to identify and, if significant, quantify
them.
 When quantification is impossible, qualitative discussion is
crucial.
 To manage externalities, projects can either adopt mitigating
technology or pay "taxes" to compensate affected groups.
 This broader view ensures a more accurate assessment of a
project's true impact on society.
6.6.Valuing Externalities
Valuing Environmental Externalities: Methods
 Including externalities like pollution or water quality
improvements in project analysis is crucial, but valuing them in
dollars is tricky.
 Before choosing a method, decide how far and how long to extend
your analysis (think impacted areas and lasting effects).
 Capturing short-term impacts within the project life is
straightforward, but long-term ones require estimating their
present value and adding them to the final analysis year.
 This ensures a more complete picture of a project's true economic
and environmental impact.
 6.6.Valuing Externalities
Valuing Environmental Externalities: Methods
Economic methods for measuring environment and resource values
Methods Observed Hypothetical
Behavior
Direct Market price Contingent valuation
Simulated
Indirect Travel cost Contingent ranking
Hedonic property value
Hedonic wage values
Avoidant expenditures
Swore: Tietenberg T., 2003, Environmental And Natural Resource Economics Pearson Education Inc.,
P.39
6.6.Valuing Externalities
Valuing Environmental Externalities: Methods
 Market price (direct) - if the costs or benefits have a market price we directly
take the market price except in this case we may have to adjust for any
divergence between the market and economic prices.
 Contingent valuation - also called willingness-to-pay. This
method provides a means of deriving values, which cannot be
obtained in more traditional way.
 The simplest version of this approach merely asks respondents what value
they would place on an external cost or benefit.
 More complicated versions ask whether the respondent would pay $X to
prevent the external cost or obtaining the benefits.
 The answer may reveal fair estimate of external costs and benefits if the
survey is managed carefully.
6.6.Valuing Externalities
Valuing Environmental Externalities: Methods
• Empirical studies revered that this method has the following
weaknesses especially if the respondents are passive user or
nonusers.
1. The tendency that the willingness to pay estimates to seem unreasonably
large;
2. The difficulty in assuring the respondents have understood or absorbed the
issues in the survey; and
3. 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 technique can give a good estimate
of these costs & benefits.
6.6.Valuing Externalities
Valuing Environmental Externalities: Methods
 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.
 Travel cost methods: This may infer the value of a recreational resource (such
as a sport fishery, a park, a waterfall such as 'Tis-isat', or a will life preserve like
Awash National Park where visitors hunt with a camera) by using information
on how much the visitors spent in getting to the site to construct a demand curve
for willingness to pay for a ''visit day''.
 Hedonic property value: This method attempts to 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. This relationship can then be
used to produce a willingness to pay for pollution reduction.
6.6.Valuing Externalities
Valuing Environmental Externalities: Methods
 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 an influx of 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.
 Contingent ranking: In this indirect hypothetical methods 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, & are asked to rank
these situations in terms of their desirability.
 These rankings can then be compared to see the implicit tradeoffs between more of the
environmental amenity and less of the other characteristics (these characteristics could be
an increase in price related to the product or loss in some benefits related to it).
6.6.Valuing Externalities
Valuing human life
 Valuing human life for policy decisions presents a complex challenge. While life itself is
priceless, scarce resources necessitate finding alternatives. One approach focuses on the
probability of death - how risk reduction translates to a decrease in expected deaths.
 If, for example, risk reduction saves 3.33 lives per million population, and people are willing to
pay $5 each for that risk reduction, then the implied value of a life is roughly $1.5 million.
However, this method doesn't directly value life itself, but the reduced risk of dying prematurely.
 Another approach, though criticized by economists, is the human capital approach, which
estimates lost future earnings due to premature death.
 This method poses challenges when comparing different income levels across countries (e.g., $3-
5 million value of life in the US). While rarely used for policy analysis, it might appear in court
settlements for individual deaths.
 Finally, the wage differential approach considers how wages vary based on risks involved in
jobs, offering insights into the value people place on safety.
6.6.Valuing Externalities
Thank You