CHAPTER 6 - 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 (economy) as a whole.

• It is based on the assessment of the utility of a project for

the society as distinct from the financial and economic
utility for the promoter group.

• While in the latter the focus is limited to financial benefits

and costs directly accruing to the enterprise, in social cost
benefit analysis the benefits and costs accruing to the
society as a whole are considered.
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 .
So, to reflect the real value of a project to society, we
must consider the impact of the project on society.
• Impact
• Positive
• Negative
• (Social Benefit)
• (Social Cost)
• Thus ,when we evaluate a project from the view point
of the society (or economy) as a whole, it is called
Social Cost Benefit Analysis (SCBA) / Economic
Analysis

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 .
• It is a technique for making enterprise
decisions, from society’s stand point.

• SCBA aids in evaluating individual projects

• Spells out broad national economic objectives

• 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
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 .
Scope of SCBA
• SCBA can be applied to both public and private investments .

Public Investment:

SCBA is important specially for the developing countries where

govt. plays a significant role in the economic development.

Private investment:

Here, SCBA is also important as the private investments are to be

approved by various governmental and Quasi-governmental
agencies which bring to bear larger national considerations in
their decisions.

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 .
• Objectives of SCBA
The main focus of SCBA is to determine
I. Economic benefits of the project in terms of
shadow prices
II. The impact of the project on the level of savings
and investments in the society
III. The impact of the project on the distribution of
income in the society;
IV. The contribution of the project towards the
fulfillment of certain merit wants (self-sufficiency,
employment etc)
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 .
Rationale for SCBA

• In SCBA the focus is on social costs and benefits of a project.

• These often tend to differ from the monetary costs and benefits of the project.

• Differences b/n the financial analysis & economic analysis are due to the following
reasons

The principal reasons for discrepancy are:

i. Market Imperfection (market prices are distorted)

ii. Externalities

iii. Taxes and subsidies

iv. Concern for savings

v. Concern for redistribution

vi. Merit wants

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 i. Market imperfection
• Market prices, which form the basis for computing the
monetary costs and benefits from the point of view of
the project sponsor, reflect social values only under
conditions of perfect competition, which are rarely, if
ever, realised by developing countries.

• When imperfection exist, market prices do not

reflect social values.

• The common market imperfections found in

developing countries are:
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 ,
1. Rationing

2. Prescription of minimum wage rates, and

3. Foreign exchange regulation.

• Rationing of a commodity means control over its price and

distribution.

• The price paid by a consumer under rationing is often

significantly less than the price that would prevail in a
competitive market.

• When minimum wage rates are prescribed, the wage paid

to labour are usually more than what the wage would be in a
competitive labour market free from such wage legislations.

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 .
• The official rate of foreign exchange in most of the
developing countries, which exercise close regulation
over foreign exchange, is typically less than the
rate that would prevail in the absence of foreign
exchange regulation.

• This is why foreign exchange usually commands

premium in unofficial transactions

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 ii. Externalities
• A project may have beneficial external effects.

• For example, it may create certain infrastructural

facilities like roads which benefits the
neighbouring areas.

• Such benefits are considered in SCBA, though

they are ignored in assessing the monetary
benefits to the project sponsors because they do
not receive any monetary compensation from
those who enjoy this external benefit created by the
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 .
• Likewise, a project may have a harmful
external effect like environmental pollution.

• In SCBA, the cost of such environmental

pollution is relevant, though the project
sponsors may not incur any monetary costs.

• It may be emphasised that externalities are

relevant in SCBA because in such analysis all
costs and benefits, irrespective to whom they
accrue and whether they are paid for or not,
are relevant.
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 iii. Taxes and Subsidies
• From the private point of view, taxes are definite costs and
subsidies are definite monetary gains.

• From the social point of view, however, taxes and

subsidies are generally regarded as transfer payments and
hence considered irrelevant.

iv. 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.

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 ;
• From a social point of view, however, the division of
benefits between consumption and savings (which
leads to investment) is relevant, particularly in the
capital-scarce developing countries.

• A birr of benefits saved is deemed more valuable than

a birr of benefits consumed.

• The concern of the society for savings and investment

is duly reflected in SCBA wherein a higher valuation is
placed on saving and a lower valuation is put on
consumption.
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 v.
v. Concern for redistribution
• A private firm does not bother how its benefits
are distributed across various groups in the
society.

• The society, however, is concerned about the

distribution of benefits across different groups.

• A birr of benefit going to an economically poor

section is considered more valuable than a birr
of benefit going to an affluent section
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 vi. Merit wants
• Goals and preferences not expressed in the market place,
but believed by policy makers to be in the larger interest,
may be referred to as merit wants.

• For example, the government may prefer to promote an

adult education programme or a balanced nutrition
programme for school-going children even though these
are not sought by consumers in the market place.

• While merit wants are not relevant from the private point
of view, they are important from the social point of view.

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Two Principal Approaches for SCBA
1. UNIDO Approach

▪ United Nations Industrial Development Organization

2. Little and Mirrlees (L-M Approach) … also

called border Price Approach [I.M.D Little

and James Alexander Mirrlees] Approach

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 THE UNIDO APPROACH TO SCBA
Traditional vs Modern approach

• The UNIDO amended its earlier approach to SCBA.

• The 1972 UNIDO Approach (Traditional):

• Valuation of inputs & outputs is based on domestic market prices

with adjustment for transfer payments (i.e., Subsidies, taxes,
and domestic interest payments).

• The domestic market is assumed to be perfectly competitive.

(This may not be true)

• The 1978 UNIDO Approach (Modern):

• Valuation of inputs & outputs is based on domestic

market prices with adjustment for:

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 .
• Transfer payments (subsidies, taxes, and domestic interests)

• Market distortions (due to restrictions & regulations)

• Wage rate distortions – use of shadow wage rate (SWR)

recommended

– Exchange rate distortions (due to restrictions on imports,

excessive import tariffs or import duties, and rationing on foreign
exchange transactions or exchange rates) – use of shadow
exchange rate (SER) recommended

• The Modern approach of the UNIDO eliminates the

limitations of the earlier (traditional) approach

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 UNIDO Approach
The UNIDO method of project appraisal involves five stages:

1. Calculation of the financial profitability of the project measured at market prices.

2. Obtaining the net benefit of the project measured in terms of economic (efficiency)
prices.

3. Adjustment for the impact of the project on savings and investments.

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 stages of appraisal measures the desirability of the project from different angle.

• The measurement of financial profitability of the project in the first stage is similar to the
financial evaluation

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 ,
. Stage – 1: Financial profitability

Calculation of financial profitability of the project

a) A good technical and financial analysis must be done
before a meaningful economic (social) evaluation
can be made so as to determine financial
profitability.
b) Financial profitability is indicated by the Net Present
Value (NPV) of the project, which is measured by
taking into Account inputs (costs) and outputs
(benefits) at market price
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Stage – 2: Net benefit in terms of economic (efficiency or shadow) prices

Obtaining the net benefit of the project at economic (shadow) prices

a) The commercial profitability analysis (calculated in stage 1)

would be sufficient only if the Project is operated in Perfect
market. Because, only in a perfect market, market prices can
reflect the social value

b) If the market is imperfect (most of the cases in reality), net

benefit of the Project is determined by assigning shadow Prices to
inputs and outputs.

Therefore, developing shadow pries is very much vital.

Shadow prices reflect the real value of a resource (input or output) to

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society
. • The term "Shadow Price" or "Shadow Pricing" is used to refer to
monetary values assigned to currently unknowable or difficult to
calculate costs

• Suppose that a project generated one additional unit of

education.

• The value of that additional unit of education to the recipient

country is given by the increase in welfare that the society in
question would obtain from that additional Unit.

• It is mandatory to measure economic benefits & costs in terms of

efficiency prices while appraising projects from the perspective
of society.
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 Stage 3 : Adjustment for the impact of
the project on Savings and investment
The purpose of this stage is to

1.Determine the amount of income gained or lost

because of the project by different income groups
(such as business, government, workers, customers etc)

2.Evaluate the net impact of these gains and losses on

savings

3.Measure the adjustment factor for savings and thus the

adjusted values for savings impact

4. Adjust the impact on savings to the net present value

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calculated in stage two.
 Stage – 4: Income distribution impact
Adjustment for the impact of the project on
Income distribution

• Many government regard redistribution of income in

favour of economically weaker sections or economically
backward regions as a socially desirability objectives.

• Due to practical difficulties in pursuing the objective of

redistribution entirely through the tax, subsidy, and
transfer measures of the government, investment
projects are also considered as investments for income
redistribution and their contribution toward this goals
is considered in their evaluation.
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 .
• Distribution Adjustment Factor (Weight) is calculated, and the
impacts of the project on income distribution have been valued by
multiplying the adjustment factor with the particular income of a
group.

• This value will then be added to the net present value re-
calculated in stage three to produce the social net present value of
the project

• This call for suitably weighing the net gain or loss by each group,
measured earlier, to reflect the relative value of income for
different groups and summing them.

• This stage provides a value on the effects of a project on income

distribution between rich and poor and among regions
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 Stage – 5: Adjustment for Merit and Demerit Goods

A merit goods are whose social value is more than its economic value

• Example :A project to supply clean drinking water to an area is socially

more desirable than a project to set up a brewery which may have a
much better return on investment the claim drinking water is merit good
where as the liquor produced by the brewery is a demerit good

The methodology is as follows,

1. Estimate the economic value

2. Estimate the social value

3. The adjustment factor is the difference between the ratio of social value
to economic value & unity, i.e

• Social value/Economic value

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 .
4. Multiply the economic value by the adjustment factor to obtain
the adjustment

5. Add the adjustment to the PV of the project

Example , Consider a brewery whose present value is Br 10 m in

terms of consumers willing to pay.

It is estimated that the social value of the liquor is no more than its
cost of production ( assumed to be 55%if the market price)

• Adjustment factor = 55/100 -1=- 0.45

• Adjustment = 10m (-0.45) = -4.5 m

• Add this to NPV 10m+(-4.5) = 5.5 m

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 .
• As liquor is a demerit good, the adjustment is
negative and the NPV of the project is reduced

• To sum UP, the five stage UNIDO method

computes the NPV of the project in terms of its
social costs and benefits & Provide a
methodology to select projects on the basis of
their value to society rather than on their
financial merit alone
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 Exercise
Consider a project for which the following information is available:

i. The present economic value of the output of the project is 250,0000.

ii. The output of the project has a social value which exceeds its
economic value by 20 per cent.

Given this information:

a) Calculate the adjustment factor

b) Calculate adjusted value

c) Determine the the net present value of the project in

terms of socially acceptable consumption

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 Solution
a) The adjustment factor = (120/100)-1 = 0.2

b) The adjusted value = 0.2 * 250,000 = 50,000

c) The net present value of the project in terms of socially

acceptable consumption =

250,000 + 50,000 = 300,000

• Where the socially valuable output of the project does not

appear as an output in the economic analysis-as is the case
where the project generates employment-the procedure is
somewhat different.

• In such a case the output is treated like externalities and its

valuation in social terms is the adjustment.
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 Little-Mirrlees Approach

❑I.M.D. Little and James A. Mirrlees have developed an

approach to SCBA which is famously known as L-M
approach.

❑ The core of this approach is that the social cost of

using a resource in developing countries differs
widely from the price paid for it.

• Hence, it requires Shadow Prices to denote the real

value of a resource to society (mentioned earlier).

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Similarities b/n UNIDO & L.M Approach

1.Calculating accounting (shadow) prices particularly for

foreign exchange savings and unskilled labour.

2.Considering the factor of equity (redistribution of

income),

3.Use of DCF analysis

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Difference
UNIDO L.M
Measures costs and benefits in Measures costs and benefits in
terms of domestic currency terms of international
prices(border prices
Measures costs and benefits in Measures costs and benefits in
terms of consumption terms of uncommitted social
The stage-by-stage analysis income
recommended by the UNIDO The L-M approach, however,
approach focuses on efficiency, tends to view these
savings and redistribution considerations together

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 Shadow Prices (SCBA)
The resources of input and output of a project are classified into:
Labour,Traded goods & Non-traded goods.

Therefore, to find out the real value of these resources, the following values are to be calculated.

a. Shadow wage rate (SWR).

b. Shadow price of traded goods

c. Shadow price of Non-traded goods

a. Shadow Wage Rate (SWR)

• The shadow wage rate is an important but difficult-to-determine element in SCBA.

• It is a function of several factors:

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 .
i. The marginal productivity of labour (The value of the
output foregone due to the use of a unit of labor);

ii. The cost associated with urbanization (cost of

transport, urban OHs, etc.); and

iii. The cost of having an additional amount committed

to consumption when the consumption of a worker
increases as a result of the higher income he enjoys in
urban employment.

• The purpose of computing the SWR is to determine the

opportunity cost of employing an additional worker in the

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project. 35
 Shadow price of Traded Goods

• Shadow price of traded goods is simply its border or

international price.

• If a good is exported, its shadow price is its FOB Price.

• If a good is imported, its shadow price is its CIF price.

• If the foreign demand is not perfectly elastic, the marginal

export revenue is substituted for the FOB prices.

• Similarly, if foreign supply is not perfectly elastic, the

marginal import cost is substituted for the CIF price.

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Chapter summary
• Social Cost-Benefit Analysis (SCBA) is a methodology for appraising projects from the social

point of view.

• It aids in evaluating individual projects within the national planning framework. It focuses on

social costs and benefits of a project.

• The financial cost and benefit of a project differs from its social cost and benefit due to market

imperfection, externalities, taxes, concern for saving, concern for income redistribution and

merit wants.

• SCBA is typically used by governments to evaluate the desirability of a given intervention.

• The costs and benefits of the impacts of an intervention are evaluated in terms of the public's

willingness to pay for them (benefits) or willingness to pay to avoid them (costs).

Inputs are typically measured in terms of opportunity costs - the value in their best alternative

use. The guiding principle is to list all of the parties affected by an intervention, and place a
10/29/2022 monetary value of the effect it has on their welfare as it would be valued by them 37
 .
• Unlike the financial cost and benefit of a project, its social cost
and benefit are valued at shadow/boarder prices.
• A key issue in shadow pricing is whether a good is tradable or
not.
For tradable goods, the shadow price is FOB price for export and
export substitutes and CIF price for import and import
substitutes. For non-tradable goods, the domestic price shall be
converted in to equivalent shadow price by using the social
conversion factor (SCF).
• The process involves, whether explicitly or implicitly, weighing
the total expected social costs against the total expected social
benefits of a project in order to choose the best or most
profitable option.
• A hallmark of SCBA is that all benefits and all costs are
expressed in money terms, and are adjusted for the time value of
money, so that all flows of benefits and flows of project costs
over time (which tend to occur at different points in time) are
expressed on a common basis in terms of their present value.
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 .
• The process involves monetary value of initial and ongoing
costs vs. expected return. Constructing plausible measures
of the social costs and benefits of specific project is often
very difficult.
In practice, analysts try to estimate costs and benefits
either by using survey methods or by drawing inferences
from market behavior.
SCBA attempts to put all relevant explicit as well as implicit
costs and benefits on a common temporal footing.
A discount rate is chosen, which is then used to compute all
relevant future costs and benefits in present-value terms.
• When possible, project’s social benefits and costs should
be estimated and included even if they are not easily
quantifiable.
• If some costs and benefits cannot be accurately
estimated,
they should at least be listed, along with the likelihood of
their occurrence and their expected impact.

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 .
• productivity, decision making, or data processing; better
management control; increased job satisfaction and
employee morale, number of jobs created (both directly
and indirectly), amount of state tax revenue generated;
etc.
• Project’s social costs might include equipment costs
(initial outlay plus ongoing operating costs); software
costs (costs of acquiring, maintaining, supporting, and
operating); human resource costs (salaries, as well as
costs of hiring, training, and
relocating staff); site preparation costs; installation and
conversion costs; supplies; overhead; financial charges;
environmental pollution; etc

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 .
• The practice of SCBA differs between countries and
between sectors (e.g. transport, health)within countries.
• Some of the main differences include the types of impacts
that are included as costs and benefits within appraisals,
the extent to which impacts are expressed
in monetary terms and differences in discount rate between
countries.
Agencies across the world rely on a basic set of key cost-
benefit indicators, including present value of benefits
(PVB); present value of costs (PVC); net present value
(NPV), benefit cost ratio (BCR), internal rate of return
(IRR); etc.

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 .
• The accuracy of the outcome of a cost-benefit analysis
is dependent on how accurately costs and benefits
have been estimated. The outcomes of cost-benefit
analyses should be treated with caution, because they
may be highly inaccurate.

• In fact, inaccurate cost benefit analyses may be

argued to be a substantial risk in planning, because

inaccuracies of the size documented are likely to lead to

inefficient decisions.
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