Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

CHAPTER 3: ECONOMIC ANALYSIS OF PROJECTS

3.1 Introduction

Remember that financial analysis is based on market price and focuses on the profitability of the
project from an individual’s point of view. However,

1. The project analyst must not only be sure that a proposed project will be profitable enough to
attract investment but also that the project will contribute sufficiently to the growth of national
income.
2. Prices could be distorted because of many factors. Only in very unlikely conditions of perfect
competition and absence of externalities, government interventions, taxes and other market
distortions, will financial analysis of a project indicate whether or not a project will make a
positive contribution to society’s welfare. So governments must choose projects on the basis of an
economic analysis if they wish to promote the community’s welfare.

These two facts necessitate the importance of another project analysis method which can help to adjust
with respect to different aspects. Another alternative and /or corrective approach is economic
analysis. Thus,

 Economic analysis, unlike financial analysis, is a methodology developed for evaluating

investment projects from the point of view of the society (or concern) as a whole.
 Economic analysis also questions the applicability of market price (failure of market and
absence of information) to value costs and benefits in a project cash flow.

The Rationale for Economic Analysis

The major conditions under which it is impossible to use market prices to assess the economic
worth of projects can be grouped under the following major headings:
 Government interventions
 the existence of externalities and public goods ( producer and consumer surplus)
 Existence of imperfect knowledge, which the neoclassical model assumes

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 1

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

Government interventions and/or failures in goods markets

i. Failure in domestic goods markets
People’s willingness to pay reflects the true value of a commodity and it is traditionally reflected
by the market price of the commodity. However, market price of that commodity measures what
people are willing to pay if and only if there is no rationing of scales or price controls in the
market, there is no consumer’s surplus from the consumption of the good, and there is no
monopoly.

ii. Trade protection and intervention in the markets for internationally traded goods
Governments frequently intervene in import markets by imposing quotas and tariffs to protect
infant industries or activities that are internationally competitive. Tariffs and quotas will cause
divergence between local market prices and the world prices for internationally traded goods.

Government interventions and/or failures of factor markets

The true economic value of the factors of production used by the project, its marginal social cost,
is measured by the opportunity cost of the factors of production. The market price of an input
will equal to its opportunity cost of production if there are no rationing, price controls or taxes in
factor markets, there is no producer’s surplus in the market price of the input, and there are no
monopsony buyers.

i. Intervention in the Labour market

Labour markets are frequently regulated by fixed minimum wage rates by many governments.

ii. Intervention in Capital market

In order to encourage investment interest rates are often kept below the market clearing level. On
the other hand, in order to encourage saving interest rates are set above the market clearing level.

iii. Intervention in Foreign Exchange market

Many countries often determine and manage their exchange rate through central government
bodies. In our country the National Bank of Ethiopia fixes the official exchange rate.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 2

 Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

Existence of Externalities and public goods

Another reason why the perfect world of neoclassical theory fails to represent the real world is
the existence of public goods and externalities. A financial analysis of a project that uses or
produces public goods and externalities, therefore, will fail to capture the full impact of a project
on the community’s welfare.

Externalities are created in the process of producing, distributing and consuming goods and
services. There are positive and negative externalities that are not directly felt by the people who
buy the products and hence may not be reflected in the price they are willing to pay for it.

Public goods are goods and services whose use by one person does not reduce their availability
to other people. They are also non-exclusionary goods available to everybody. If the project uses
public goods as inputs or produces those as outputs it would be wrong to value them at their
market price of zero in any economic analysis of the project. They should be valued at the
amount that is estimated by people’s willingness to pay for them.

Economic Vs Financial Analysis

Basically, the procedures followed and the criteria used (NPV, IRR, BCR) are the same in economic
and financial analysis of projects. But the values, which the NPV, IRR and BCR assume, are different
in economic analysis and financial analysis. The main factors, which explain this difference, are:

Items considered as inputs and outputs

Often, some real costs and benefits attributed to projects do not appear among its inputs and outputs
when it is analyzed from the enterprises viewpoint and, therefore, they do not enter the calculations of
financial NPV, IRR, and benefit cost ratio. The main reason for excluding certain cost and benefits is
that they are considered “external”1 to the enterprise. But costs or benefits viewed as “external” to the
enterprise are “internal” when they are considered from the economy’s angle; somebody pays for these

1
An externality, also referred to as an external effect, is a special class of good, which has the following characteristics:
(i) It is not deliberately created by the project sponsor but is an incidental outcome of legitimate economic activity.
(ii) It is beyond the control of the persons who are affected by it, for better or for worse.
(iii) It is not traded in the market place.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 3

 Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

“external” costs and somebody receives these “external” benefits, even if it is not the enterprise.
Consequently, to the extent that they can be measured and valued they should be included in the
calculations of the economic NPV, IRR, and BCR. Since SCBA seeks to consider all costs and
benefits, to whomsoever they may accrue, external effects need to be taken into account.

The valuation of external effects is rather difficult because they are often intangible in nature
and there is no market price, which can be used as a starting point. Their value is estimated by
indirect means. For example:
 The benefit of information provided by the oil field to neighboring oil fields may be equated with what the
neighboring oil fields would have spent to obtain such information.
 The value of better transport provided by the approach roads may be estimated in terms of increased
activities and benefits derived there from
 The benefit from the training programme may be estimated in terms of the increased earning power of
workers.
 The cost of pollution may be estimated in terms of the loss of earnings .as a result of damage to health
caused by it and the cost of time spent for coping with unhygienic surroundings.
 The cost of noise may be inferred from the differences in rent between the noise-affected area and that of
some other area, which is comparable except for the level of noise.
 The harmful external effect of the highway may be measured by the consumer willingness to pay for the
output of farmer, which has been reduced due to the highway.

Prices used
Another difference between financial and economic analysis is that even inputs and outputs
“internal” to both the enterprise and the economy are valued differently. In financial analysis the
rule is to value inputs and outputs at actual market prices, at the same time in economic analysis
shadow or Efficiency or Accounting prices are employed.

Taxes, subsidies and other transfer payments

The other reason why financial and economic NPV and IRR might differ emanates from the
treatment of taxes, subsidies and other transfer payments. Taxes and customs duties from which
the enterprise is not exempted are taken as cost in financial analysis although they do not reflect
commitment of real resources; for this reason they are excluded from the calculations of the
economic NPV and IRR.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 4

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

 In addition to the factors discussed above, the impact of the project on savings, its effect
on redistribution, and the consideration for merit goods are also seen as the other factors
that entail differences between financial and economic analysis of projects:

Concern for Savings: One Birr of benefits saved is deemed more valuable than a birr of
benefits consumed. The concern of society for savings and investment is properly reflected in
SCBA wherein a higher valuation is placed on savings and a 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. The society, however; is concerned about the
distribution of benefits across different groups. One Birr of benefit going to a poor section is
considered more valuable than a Birr of benefit going to an affluent section.

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.

For the reasons discussed above the financial and economic analysis of a project will
show a different picture, particularly as regards the NPV, IRR, and BCR. In deciding
. on the acceptance or rejection of such projects, the economic criterion is superior to
the financial one, and when a project passes the economic test it is an acceptable
project for the country.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 5

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

3.2 The Concepts, Essential Elements and Procedures of an Economic Analysis

The economic analysis of a project has many features in common with a financial analysis:
1. Both involve the estimation of a project’s cost and benefits over the life of the project for
inclusion in the project’s cash flow.
2. In both the cash flow is discounted to determine the project’s net present value, or other
measures of project worth.
3. Both may also use sensitivity or probability analysis to assess the impact of uncertainty
on the project’s NPV.

But an economic analysis goes beyond a financial analysis appraisal, as it will also involve all or
some of the following adjustments. In other words the essential elements of economic analysis
include:
a) The elimination (deduction) of transfer payments within the economy from the project’s
cash flow.
b) The estimation of economic or shadow prices for project inputs and produced outputs
(including internationally traded and non-traded goods) to correct for any distortions in their
market prices.
c) The estimation of economic prices for non-produced inputs (including labour, natural
resources and land) to correct for any distortions in their market prices.
d) The valuation and inclusion of any externalities created by the project.
e) The valuation and inclusion of any un-priced outputs and inputs such as public goods

The major steps in economic analysis can be summarized as:

1. Identification of cost and benefit items that need to be incorporated in economic analysis
2. Quantify both the cost and benefit items
3. Revalue the cost and benefit items; i.e. what prices to use?

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 6

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

3.2.1 Costs and Benefits in Economic Analysis

Identifying costs and benefits is the first and most important step in economic analysis. The
projected financial revenues and costs are often a good starting point for identifying economic
benefits and costs. The following points represent steps and important elements in identifying
costs and benefits in economic analysis.

Cash Flow Analysis

We base financial analysis of projects on cash flow analysis. For every period during the
expected life of the project, the financial analyst estimates the cash the project is likely to
generate and subtracts the cash likely to be needed to sustain the project. The net cash flows
result in the financial profile of the project. Because we base the financial evaluation of a project
on cash flows, it omits some important items that appear in profit-and-loss statements. For
example, we use depreciation and depletion charges in income statements and balance sheet
accounting to arrive at an estimate of net profit. These concepts are imputed financial costs that
do not entail cash outlays and consequently do not appear in either the financial or economic
flows used to calculate NPVs and rates of return (IRRs).

Sunk Costs

For both financial and economic analysis, the past is the past. What matters are future costs and
future benefits. Costs incurred in the past are sunk costs that cannot be avoided. When analyzing
a proposed project, sunk costs are ignored. Economic and financial analyses consider only future
returns to future costs.

Physical Contingencies (+)

Physical contingencies represent expected real costs and, unlike price contingencies, we include
them in project economic costs in the analysis. Physical contingencies may be allocated to
specific items of cost, or they may be unallocated, that is, not attributable to expected cost
increases for any specific item in the project costs.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 7

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

Transfer Payments (-)

Some payments that appear in the cost streams of financial analysis do not represent economic
costs, but merely a transfer of the control over resources from one group in society to another.
Hence transfer payments have to be excluded from all estimates of economic costs and benefits
during the economic analysis of a project.
It is to be noted that transfer payments affect the distribution of income though they don’t
affect the overall level of resources available to the economy/society/.

Taxes versus User Charges (-T and + Charges): Some care must be exercised in identifying
taxes. Not all charges levied by governments are transfer payments. Some are user charges levied
in exchange for goods sold or services rendered. Water charges paid to a government agency, for
example, are a payment by farmers to the irrigation authority in exchange for the use of water.

Subsidies (-): Subsidies are taxes in reverse. As with taxes, analysts must keep track of the
recipient's benefit and the giver's cost to present a complete picture of project flows. Because the
flows net out, they are not a cost to society.

Donations and Contributions in Kind (+): In some cases, the project entity receives goods and
services free of charge. For example, hospitals may receive costly medical equipment as gifts
from the private sector or nongovernmental organizations.

Interest Payments and Repayment of Principal (-): The reason for excluding debt service
from economic analysis is that debt service does not entail a use of resources, but only a transfer
of resources from the payer to the payee.

Externalities (±)
A project may have a negative or positive impact on specific groups in society without the
project entity incurring a corresponding monetary cost or enjoying a monetary benefit.

Consumer Surplus (+)

In some cases, a project may not only increase output of a good or service but also reduce its
price to consumers. In principle, this increase in consumer surplus should be treated as part
of the benefits of the project.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 8

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

3.2.2 Determining Economic Values

Financial costs and benefits are valued at the prices that the project entity is expected to pay for
them. Usually these are prices set by the market, although in some cases they may be controlled
by government. However, these prices do not necessarily reflect economic costs to society. The
economic values of both inputs and outputs may differ from their financial values because of
market distortions created by either the government or the private sector. The differences
between financial and economic prices are rents that accrue to some group in the society and
convey important information about the distribution of costs and benefits.

Shadow prices are simply a set of prices that are believed to better reflect the opportunity cost,
i.e. the cost in their best use, of inputs and outputs. It is a price which is calculated with a certain
objective in mind such as maximizing economic growth, improving the balance of payment and
enhancing employment opportunities. It represents all non-market prices. It is the value used in
economic analysis for a cost or a benefit item in a project when the market price is felt to be a
poor estimate of economic value. It is an estimate of efficiency prices. Shadow prices reflect the
increase in welfare resulting from one more unit of an output or input being available.

Thus the economic analysis of projects requires that inputs and outputs be valued at their
contribution to the national economy, through economic prices, or alternatively called as
‘efficiency prices, shadow prices’. So shadow prices are used instead of domestic market prices
in guiding the allocation of resources since the market prices are distorted and using them would
lead to resource misallocation.

Before we deal with shadow pricing (revaluation) of specific resources, certain basic concepts
and issues of shadow pricing like: choice of numeraire, boarder parity price, concept of
tradability, national parameter and conversion factors, must be discussed:

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 9

 Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

World prices/ Border Prices

World prices are normally measured as border prices reflecting the value of a traded good at the
border or port of entry of a country. Border price is the unit price of a traded good at a country's
border (FOB for exports and CIF for imports). However, values in project financial statements
will normally be at prices received by the project -ex - factory or farm gate prices or paid by the
project for inputs. This means that for traded goods domestic margins, relating to transport and
distribution (including port handling) will have to be added to prices at the border to obtain
values at the project level.

The decomposition of these margins is referred to as border parity pricing. A parity price or
parity economic value is the price or value of a project output or input that is based on a border
price adjusted for expenses between border and the project boundary.

Thus for goods that are traded directly by a project the border parity price for the project output
is the FOB price minus the value of transport and distribution. Similarly where a project imports
an input its border parity price is the CIF price plus transport and distribution costs.

Concept of Tradability

Traded goods: Traded goods are goods that are imported or exported. That is C.I.F for imports and
F.O.B for exports. In other words, traded items are those for which
 F.O.B price is greater than domestic cost of production, or
 Items exported through government intervention by use of export subsidies and the like, or
 Imports, Marginal cost of production is greater than C.I.F price.

Non-tradable inputs and outputs: A good is regarded as non-tradable when one or more of the
following conditions are satisfied.
 If its import price (C.I.F price) is greater than its domestic cost of production and domestic cost
of production is greater than its export price (F.O.B price) or simply C.I.F > DCP > FOB.
 If it is not traded because of government intervention by means of import bans or quotas.
 If it is not traded either because of its nature (bulkiness) or it is not economical to do so.
A good might also be regarded as non-traded despite being traded if its external DD (for export)
or external SS (for import) could be regarded as fixed.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 10

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

Conversion factors
As has been stated that all project inputs and out puts should be valued at the world prices, which
are the border prices. World prices are used to measure the opportunity cost to the economy of
goods and services, which can be bought and sold on the international market. This means the
world price reflect the terms on which it can buy and sell on the world market. However, in
practice there are significant number of commodities for which there will be no direct world
price to use as a measure of economic value. Thus some world price equivalent figure needs to
be derived for these non-traded goods. To estimate the efficiency (accounting prices) for all other
non-traded gods, (inputs and outputs) we use conversion factors

A conversion factor is defined as the factor by which we multiply the actual price in the domestic
market of an input or output to arrive at its economic price when the latter cannot be observed or
estimated directly. The more then inputs and out puts are traded the less will be the need to use
conversion factors. The conversion factor is simply the ration of the shadow price of the item to
its market prices. A conversion factor is estimated simply by taking the ratio of border prices
(world prices) to domestic market prices of the good that the country traded.

The standard conversion factor

This is an all - inclusive conversion factor used in place of commodity - or sector specific
conversion factors, either because they cannot be estimated accurately, or because they do not
differ substantially from the standard conversion factor. It is a summary measure to calculate
shadow price for non-traded commodities.

In the case of Ethiopia the standard conversion factor is interpreted as a summary and
approximate quantification of the distorted markets (domestic) as compared to the international
market. It is therefore estimated as the ratio of the value of imports and exports of a country at
border prices (CIF and FOB) to their value at domestic prices.
The formula for computing the standard conversion factor is given as:
MX
ScF 
( M  Tm  Sm)  ( X  Sx _ Tx )

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 11

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

Where = M and X are total imports and exports respectively at world prices converted at the
official exchange rate.
= Tm and Tx are the total trade taxes on imports and exports respectively.
= Sm and Sx are total trade subsidies on imports and exports respectively.
All values should refer to the same year or to an average over the same period. The shadow price
(world equivalent price) of non-traded commodity is calculated by multiplying the net of taxes
domestic prices of one commodity by the SCF.

To summarize, although it is recommended that a different shadow price can be estimated for
different non-traded goods, it is useful to have available a standard conversion factor that can be
used for non-traded goods which remain after one or two rounds of decomposition. For this
purpose, the ratio of the value of border prices of all exports and imports to their value at
domestic prices might be used. The SCF is revised from time to time by the central economic
authorities and adopted by planning bodies.

National parameters:
There are some important parameters that have general applicability in the sense that they are
used in all projects. These parameters should take the same value in all projects although they
can change from time to time. In other words such parameters are national in that they apply to
all projects regardless of their sector, and they are economic because they reflect the shadow
price of the items concerned. They are estimated by the central planners a dare taken as given by
the project analyst. A typical list of national economic parameters covers conversion factors for:

 Unskilled and skilled labor

 Some of the main non-traded sectors
 Some aggregate conversion factors such as consumption conversion factor, a standard
average conversion factor, the discount rate, etc.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 12

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

Numeraire / Unit of Account

One of the earliest decisions that an analyst confronts is the choice of currency and price level in
which to conduct the analysis. Financial analysis is usually conducted in the currency of the
country undertaking the project and at prevailing market prices. Economic analysis can be
conducted in domestic or foreign currency and at domestic or border price levels.

1. When the analysis is done in domestic currency at the domestic price level, the analyst
is using the same price level and currency that a financial analyst would use. In most
countries, the domestic price level is the price level used to keep national accounts, the
price level used by the government to reckon its taxes and expenditures, and the price
level used by business. For purposes of economic analysis, when we use domestic
currency at the domestic price level as numeraire:
 The prices of traded goods and services are taken at the “border price” and
converted into domestic currency at a “shadow” exchange rate.
 The prices of non traded goods and services, such as cleaning services, are taken
at their market prices.
2. When the analysis is done in domestic currency at the border price level as a
nummeriare:
 The prices of all imports and exports, for example, are taken at the border price
and converted into domestic currency at the prevailing market or official
exchange rate.
 The prices of services, such as cleaning services are converted to their border
price equivalent by means of a “conversion factor.”
3. If the analysis is done in foreign currency and the border price level as a nummeriare:
 the prices of imports and exports remain in foreign currency,
 the prices of such things as cleaning services are first converted to their border
price equivalent by means of a conversion factor, and then to their foreign
currency equivalent by means of the prevailing market or official exchange rate.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 13

 Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

3.2.3 Economic valuation (Revaluation) of selected Items in Economic Analysis

1. Economic Value of Tradable and Non Tradable Goods

Valuation of tradable items
A good is fully or potentially tradable when the increase in its consumption results in a
corresponding increase in imports and decrease in export or when the increase in production results
in a corresponding increase in export or decrease in import. For traded goods (tradable), the
opportunity cost to an economy or shadow price is the boarder price translated in domestic currency
at the market exchange rate.
The major causes for the differences between the economic value of traded goods and their domestic
market prices are due to the incidence of taxes on trade (these are removed to derive economic
values) and the extent to which the economic value of foreign exchange exceeds its market price
value (i.e. the level of the shadow exchange rate).

Therefore, for tradable the international price is the measure of its opportunity cost to the country.
The reason is that for tradable goods it is possible to substitute imports for domestic production and
vice versa; similarly it is possible to substitute exports for domestic consumption and vice versa.
Hence, the international price also referred to as the boarder price, represents the ‘real’ value of the
good in terms of economic efficiency.

Valuation of Non-tradable commodities

Some goods and services such as land, building, transportation, and electricity are not amenable to
foreign trade. Hence, there is no boarder price for them. Accounting prices for non-traded items are
defined in terms of marginal social cost (MSC) and marginal social benefit (MSB). The marginal
social cost of a good is the value in terms of accounting prices of the resources required to produce
an extra unit of the good.

The value of a non-traded good thus should be measured in terms of what domestic consumers are
willing to pay; if the output of the project adds to its domestic supplies or if the requirement of the
project causes reduction of its consumption by others. In other words, the value of a non-traded
good should be measured in terms of its marginal cost of production if the requirement of the

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 14

 Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

project induces additional production or if the output of the project causes reduction of production
by other units.

For example, the marginal social cost of a bus trip is equal to the cost of marginal inputs (fuel, oil,
wear and tear of the bus etc.) evaluated at border prices plus the social wage of the driver and the
conductor. To determine, the accounting price of non-traded inputs, one should estimate the
proportion in which the DD for that input will be met from increased production and decrease in
consumption elsewhere in the economy. If the proportion of increase in production and decrease in
consumption is, say, 2:1, the accounting price of the non-traded good will be: 2/3 MSC+ 1/3 MSB

Therefore, the valuation of non-tradable is done as per the principles of shadow price discussed
above. That is, on output side,

 If the impact of the project is to increase the consumption of the product in the economy, the
measure of value is the marginal consumers’ consumers are willing to pay.
 If the impact of the project is to substitute other production of the same non-tradable in the
economy, the measure of value is the saving in the cost of production.

On the input side,

 If the impact of the project is to reduce the availability of inputs to other users, their
willingness to pay for the input represents social value;
 If the project’s input requirement is met by additional production of it, the production cost of
it is the measure of social value.

2. The valuation of primary factors of production

Elements of the shadow Wage Rate

Most people cannot travel freely between countries to sell their labor so it is not possible to
directly establish a border price for most types of labor services. The total number of unskilled
workers available in an economy cannot normally be expanded in response to market demand
unless there is substantial immigration program in the country concerned. Labor supply can only
increase as a result of long run demographic trends factors and not as a response to a market
demand. So unskilled labor cannot therefore, be valued at its marginal cost of production.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 15

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

On the other hand, as the supply of skilled labor can be increased by raising training levels its
supply may be more responsive to market demand at least in the medium term. Labor services
are therefore, a form of non-traded primary factor and can be valued in much the same way as
non-traded goods and services. However, labor cannot be treated just like another factor of
production and should be treated uniquely

Distortions in the Labor Market.

Distortions in the labour market for unskilled and skilled labour may result in the wages of such
labour exceeding their marginal revenue product, valued in economic prices. Examples of
labour market distortions are minimum wage legislation. Centralized wage fixing and restrictive
union practices. These distortions are usually more common in urban areas because government
control and union activity are stronger there. Nevertheless, it is believed that distortions exist
only in the market for unskilled labour. The market for skilled labour is taken to be relatively
competitive and there may not be the need for special shadow salaries for skilled personnel. It is
assumed that the market for skilled labour reflect marginal productivities subject to the overall
distortions of the economy as expressed by the standard conversion factor (SCF).

The valuation of unskilled labor

Since unskilled labour is generally in fixed supply when a project uses labour it will have to
draw it away from other employment somewhere in the economy. This labour may actually
come from another sector such as agriculture. If anon-traded factor is removed away from other
users, its economic cost is what they were willing to pay for it.

If labour markets were generally efficient and there is no government intervention, the market
wage rate paid for this labor should reflect the contribution the marginal worker makes to the
total revenue of the employer. However, in market distortions it would be necessary to
determine the true cost of the project labour requirements to the economy by calculating the
shadow wage rate (SWR) or the marginal social cost of labour. The basis for the derivation of the
SWR is the forgone output or labour’s marginal contribution to the revenue earned in the
occupation from which it has been drawn.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 16

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

The Valuation of Skilled Labour:

The economic cots of skilled labour are in principle estimated in exactly the same way for
unskilled labour. The significance difference though, is that there is more general agreement that
skilled labour’s wage reflect its marginal product reasonably and accurately. Two reasons are
often presented to support this argument:

1. Skilled labour is more specific, often being highly mobile in nature and wages tend to be
competitive and full employment is the rule.
2. The supply of skilled labour is increasingly equated to its present and future demand by the
Use of manpower planning techniques, which has the virtue of missing discrepancies between
supply and demand and hence relieving the price mechanism of part of the burden of adjustment.

In Sum, The project analyst should first divide the labour force into the skilled and unskilled
categories on the basis of his experience and the characteristics of the project. Then he should
value the unskilled labour at its opportunity cost, i.e., at the SWR. Skilled labour should be
treated like any other non-traded input and should be valued at market wages multiplied by the
SCF.

The valuation of Land

The term land covers not merely land parcels but other material resources such as forests, fishery
reserves, mineral deposits, etc. Thus it is important to examine economic valuation of land. In
principle, the capital value of land is the discounted value of the stream of future earnings which
it can command net of the cost of purchased inputs and labor. i.e. it is the capitalized rental
element. Where there is competitive land market prices would equal the expected future gain
from the purchase or rental of an additional unit of land. But it is not obvious that existing land
markets are sufficiently competitive for price to be an adequate guide to productivity.

The price of land: If there is no freely operating market for land in the vicinity of the project or
in similar locations in the country concerned it will be necessary to directly estimate the
opportunity cost of land. The opportunity cost of land will be the value of the net output that it
could have produced in its next best alternative use.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 17

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

Example : Where land for a factory site was previously unused its direct opportunity cost will be
zero, since no output would be lost by building the factory on the land, and only land clearing
costs can be properly attributed to the project. If an agricultural land is to be used, its economic
cost will be the sum of the discounted agricultural output value lost over the life of the project,
net of the cost of other inputs, valued either in border prices or in domestic prices.

The Shadow price of Natural Resources: If the natural resources (such as mineral deposits, oil,
natural gas deposit, etc.) are used in the project are traded they should be valued at their FOB or
CIF prices, depending on whether they impact on exports or imports at the margin. If imported
mineral is used it should be valued at CIF border price. If exported mineral is used it should be
valued at the FOB border price. If the project uses a non-traded natural resource input whose
output can be expanded this input should be valued at its supply price, its marginal cost of
production. Its supply price will be equal to the economic value of the resource that is used to
produce it. If the project uses a non-traded natural resource that is in relatively fixed supply, it
should be valued at its demand price.

3. The Economic Valuation of Foreign Exchange

Introduction: Why Economic Valuation of Foreign Exchange?
In the previous sections we have discussed how border prices are used to value the economic
benefits and the cost of project’s tradable inputs and outputs. In project appraisal the foreign
exchange earnings and costs are usually converted into local currency so that they can be
included in the project’s cash flow with its non-tradable inputs and outputs. The OER would be
applied on the border price of exported commodities, X (fob price) and to that of each of the
imported inputs, M (c.i.f. price) to value them domestically. But does the OER (the price of
foreign exchange) reflect the economic values of foreign exchange to the economy?

The official exchange rate, OER will be equal to the true economic value placed on foreign
exchange if it is able to move freely without interventions or control by the government and if
there is no rationing of foreign exchange, no tariffs or non-tariff barriers on imports and no taxes
or subsidies on exports.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 18

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

In very few countries in the world there is little or no government intervention and few
imperfections in the country’s traded goods and foreign exchange markets. There are many
distortions in the market for foreign exchange and traded goods.

The foreign Exchange premium

The questions addressed here are:
1. How to measure the extent of distortions in foreign exchange, given we recognize the
existence of distortions in the foreign exchange.
2. Are the prices of tradable goods and non-tradable goods comparable? If no, how to make
them comparable? In other words the domestic prices (determined in the domestic
market) and the border prices (determined in the international markets) are two different
prices, that call for making some adjustment or at least some rationalization if one is to
just add them up.

If the official exchange rate, OER, expressed in terms of units of local currency needed to buy
one unit of foreign exchange is fixed below their equilibrium level it is said to be overvalued.
This means that an unrealistically high value is placed on the local currency in terms of how
much foreign exchange can be bought with a unit of currency. Countries that have an overvalued
exchange rate are said to place a premium on foreign exchange or to have a foreign exchange
premium (FEP).

A FEP measures the extent to which the OER understates/overstates the true amount of local
currency that residents would be willing to pay for a unit of foreign exchange, or its true
opportunity cost to the economy.

The FEP can be measured crudely by the ratio of domestic prices to the border prices. In other
words, the FEP is measured by the ratio of the value of total trade, imports plus exports,
valued in domestic prices and therefore including the effect of tariffs and other distortions,
to the value of trade in border prices, minus one, as given in the equation below:

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 19

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

DP domestic price
FEP Crudely   1
BP border price

M (1  t )  X (1  d  s )
FEP  1
X M
M  Mt  X  Xd  Xs
 1
X M

t= taxes & tariffs imposed on imports

d= taxes on exports
s=subsidy on exports
M=import value (CIF)
X=export value (FOB)

M + Mt + X – Xd + Xs = total amount in local currency that residents are actually paying and
receiving.
X + M = actual FE value of these traded goods.

It therefore measures the true values placed on traded goods produced and consumed in the
country. The denominator shows the actual foreign exchange value of these traded goods when
they are measured at their border prices, converted to local currency at the OER. The ratio of the
domestic value to the border price value, therefore, shows the true value placed on traded goods,
relative to apparent economic values at the official exchange rate. The FEP is usually expressed
as % (that is why we subtract 1 and multiply it by 100). The final result shows the extra % that
consumers are willing to pay over and above the OER if they were able to buy currency freely
and spent it on duty free goods.

When estimating the economic prices of tradable goods in countries that have overvalued
exchange rate, it will not be correct to merely value traded goods (which may normally be
subject to tariffs) at their border prices and then convert these values to local currency at an
artificially low exchange rate. Such a process would make them appear unrealistically cheap
compared with locally produced non-tradable goods. This is because the local price of non-

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 20

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

tradable goods will over time, have adjusted upwards to equal the tariff inclusive price of traded
goods, which consumers find equally attractive.

Given a choice between a US dollars’ worth of imported goods, valued at their tariff-free border
price and converted into local currency at the official exchange rate on a US dollars’ worth of
locally produced non-tradable goods valued at their domestic market price the average consumer
would prefer a dollar’s worth of duty free imported goods. The foreign exchange required to
purchase these imported goods will therefore, have a higher value to local consumer than is
indicated by the official exchange rate. OER. Thus the project analyst must correct these
distortions in the foreign exchange and traded goods that result in a premium being placed on
foreign exchange.

If a foreign exchange premium exists, it is therefore, necessary to take into account of it in all
projects where both traded and non-tradable goods and services are included among project
inputs and outputs, or when comparing projects producing or using traded and non-tradable
goods and services. If both traded and non-tradable commodities are used or produced in a
project, they need to be valued in comparable prices before they can be added together in
net cash flow of a project.

The Shadow Exchange Rate (SER)

One way to correct for an overvalued exchange rate in project appraisal is to use a shadow
exchange rate, rather than the official exchange rate to value all foreign exchange earned and
used by the project. The SER is that rate of exchange which accurately reflects the consumption
worth of an extra dollar (or other convertible foreign currencies) in terms of one’s own currency.
That is it expresses the value of foreign exchange in terms of a unit of domestic consumption.
Thus the SER is the shadow price of foreign exchange and reflects the foreign exchange
premium. Thus one way to adjust for the overvaluation of local currency is to increase the OER
by the foreign exchange premium to obtain a shadow exchange rate.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 21

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

 FEP 
SER  OER   1
 100 
The SER can also be derived from the definition of the FEP.
 Value of trade in domestic prices 
SER  OER  
 Value of trade in border prices 
 M (1 t )  x (1  d  s) 
 OER  
 M  x 
Where: x, M, t, d, and S are defined as before the value of export (FOB), value of import (CIF),
tariffs imposed on imports, and export subsidy.

Example: If FEP is 100 percent and if the OER is 1 us dollar is equivalent to birr 10, then the
shadow exchange rate can be estimated by:
 100 
SER  Birr 10 / us $   1  birr 20 / 1 us $
 100 
The Shadow exchange rate would therefore, be birr 20 per 1US $. Thus foreign exchange infract
has twice the value indicated by the official exchange rate.

Example: if consumers in an economy would be willing to pay 20 percent more than the OER to
obtain foreign goods, then the foreign exchange premium is 20 percent and the OER would be
increased by 20 percent to obtain the SER. Thus if the OER were Birr 10 = $US1, then the SER
would be Birr 12 = $US1. (i.e. Birr 10 *1.2 =12).

4. Determination of the Social Discount Rate (opportunity cost of capital)

The crucial question is how to determine the appropriate level of the social discount rate. In
financial analysis of a project the opportunity cost of capital to the implementing firm is the rate
at which the project implementer could borrow or lend, depending on whether he or she is a net
borrower or lender in the market. In an economic analysis of project the social discount rate
should reflect the social opportunity cost of the capital funds used to the country as whole. The
market interest rate cannot often be employed as the social discount rate because of
imperfections in the capital market. These will derive the wedge between the market cost of
capital and its demand and supply price. In some situation, however, if distortions in the capital
market are not great and are difficult to measure, the market interest rate may be the best
approximation of the social discount rate.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 22

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

As a result of the different interpretations of the rate, different approaches have been followed in
estimating the value of the discount rate. But two interpretations of the discount rate, i.e., as

• Opportunity cost of capital

• A screening device are more generally accepted and easier to comprehend.

When considered as the price of capital, the discount rate sounds like the familiar interest rate
charged by financial institutions on loans they make. But since capital or finance markets of most
developing countries seem to be distorted, it is necessary to estimate a shadow price for the
market interest rate. This shadow price, like any other shadow price, is nothing else than an
opportunity cost, i.e. the opportunity cost of capital.

If the discount rate is considered as a screening device, this discount rate is set by the central
authorities at a level that allows just enough projects to pass the NPV criterion as are required to
absorb all investible funds. The magnitude of these funds is estimated by the central authorities.
Under the screening device interpretation, we can say that the discount rate is what the planners
have decided it should be. The central planners need available information and should make a
number of assumptions in estimating the supply of funds and the tentative demand for
investment in the form of forthcoming projects. Only when this information is available can the
planners decide what the discount rate should be. Like any other national parameter the discount
rate is under constant review by the central economic authorities and is revised to take into
account changes in the demand and supply of investible funds.

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 23

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

3.3 Approaches in Economic Analysis (Incorporating Foreign Exchange Premium)

When economists first started using shadow prices the most obvious procedure appeared to be to
use domestic resources as the unit of account and to estimate the scarcity value of foreign
exchange through the use of a shadow exchange rate. This procedure corresponds to what is now
described as the use of a domestic price numeraire:

UNIDO approach (squire and van der tak (1975)) = SVT approach or domestic price numeraire

The alternative approach is to use a unit of foreign exchange, still expressed in local currency
unit, as the numeraire. This procedure is described as the use of a world price numeraire:

Little and Mirrlees approach (Little and Mirrlees (1974)) = LM approach or OECD / World
Bank or WORLD PRICE NUMERAIRE

UNIDO approach (Domestic price numeraire)

Value of all traded goods (TG) + non traded goods (NTG) in domestic price equivalent
Example: Valuation of project inputs and outputs
If FEP = 30% and SER = OER (1+0.3) = 1.3 OER

Import Category FA EA
 CIF at OER 250 -
 CIF import at SER = 1.3 OER - 325
 Import tariff (40%) 100 0
 Internal transport 50 50
 Handling and distribution* 50 20
Includes 60 % rent
Total 450 395

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 24

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

Export Category FA EA
 FOB at OER 1200 -
 FOB at SER = 1.3 OER - 1560
 Export tax (10%) 120 0
 Transport to port 40 30
Includes 50 % fuel tax and fuel
constitute only half of transport
cost
Total 1040 1530

The Little-Mirless approach (border price numeraire)

Traded------ at border price [OER]
Non traded …….at DP X CF (conversion factor) = border price

Category FA EA
 cif at OER 250 250
 Import tariff (40%) 100 0
 Internal transport 50 40
Conversion factor = 0.8 (50 X 0.8)
 Handling and distribution 50 14
Conversion factor = 0.7
and 60 % rent included
Total 450 304

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 25

Project Analysis Lecture Note, 2016 CH 3: Economic Analysis of Projects

Export Category FA EA
 Fob @ OER 1200 1200
 Export tax (10%) 120 0
 Transport to port 40 24
Conversion factor = 0.8
Include 50 % fuel tax and fuel
constitute 50 % of transport cost
Total 1040 1176

By: Nega Ejigu (Lecturer, Department of Economics, BDU) Page 26