Icfal Project Appraisal Scba I

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 international 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%)

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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)