Chapter six: Economic and Social Analysis
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At the end of this chapter students will be able to describe:
Purpose of Economic Analysis of the project
Economic and social cost benefit analysis of the project
Approaches of measuring Economic Cost & Benefit of a
project
Economic Export & Import Parity Price
Valuation of Non-traded Goods of the project
Valuing Externalities of the projects
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Economic analysis of projects is similar in form to financial
analysis in that:- both assess the profit of an investment.
However, the concept of financial profits not the same as the
social profit of economic analysis.
The financial analysis of a project identifies the money profit
accruing to the project operating entity,
whereas social profit measures the effect of a project on the
fundamental objectives of the whole economy.
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These d/c concepts of project are reflected in the d/t items
considered to be costs and benefits and in their valuation.
E.g.:- Money payment made by the project operating entity
for labor (wages) is financial cost.
But it will be an economic cost only to the extent that:- the
use of labor in this project implies some sacrifice elsewhere
in the economy with respect to output and other objectives of
the country.
If project has economic cost that doesn't involve money outflows
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from the project entity; it will not be considered as financial cost.
Generally:- some costs & benefits that may appear in financial
accounts may not appear in the economic accounts & vice versa.
Similarly, some costs & benefits may be lower (higher) in
financial but higher (lower) in economic analysis even though
they appear in both.
The extent to which economic costs & benefits diverge from
their counterpart financial costs & benefits are:- based on the
presence & extent of market imperfections.
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Use of economic prices (shadow prices, efficiency prices, or
accounting prices) is an important means for assessing the
economic merits of a project to a country.
Once financial price for costs & benefits have been determined
& entered in the project accounts:-
o the analyst estimates the economic value of a proposed
project to the nation as a whole.
The financial prices are the starting point for the economic
analysis:-
6 o It adjusted to reflect the value to the society asJunewhole
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When the market price of any good or service is changed to
make it more closely represent the opportunity cost to the
society:-
the new value assigned becomes the “shadow price” or
“accounting price” or “economic price” or “efficiency
price”.
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6.1. Purpose of Economic Analysis
I. Selection of alternatives
The main purpose of project economic analysis is to help
design and select projects that contribute most to the welfare
of a country.
When used solely, economic analysis serves only a very
limited purpose & hence should not be the only basis for
financial decision.
Optimal decision can be made based on merit of all
aspects:- (financial, economic, fiscal impact,
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II. Identification of winners and losers
A good project contributes to the country’s economic output;
hence it has the potential to make everyone better off.
o However, normally not everyone benefits, and someone may
lose.
o Groups that benefits from a project aren’t necessarily those
that incur the costs of the project.
Identifying those who will gain, those who will pay & those will
lose:
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o gives the analyst insight into the incentives that various
III. Environmental impact
A d/c b/n society’s point of view & private point of view
concerns:- costs/benefits attributable to the project those not
reflected in its cash flows.
The effects of the project on the environment, both negative
(costs) and positive (benefits), should be taken into account &
if possible, quantified and assigned a monetary value.
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6.2 Economic Benefit and Cost Analyses
A project will be profitable to society if the economic benefits of
the project exceed the economic costs or
If net present value (NPV) of the project to society is greater than
zero.
Broadly, there are two methods of measuring economic costs &
benefits of a project:
A. UNIDO approach and
B. Little-Mirrlees (L-M) approach
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A. UNIDO approach
In this method economic benefits & costs measured
By domestic prices using consumption as the numiraire,
with adjustment made for the d/c b/n market prices & economic
values &
making domestic & foreign resources comparable using
shadow exchange rate (SER).
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In this method:- for traded commodities, first goods will be
adjusted for any distortions in the domestic markets.
After this adjustment is made:- the adjusted domestic price will
be multiplied by SER to make domestic resources be
comparable with foreign resources.
o The easiest way for adjusting domestic market distortions is to
use border prices:-
c.i.f., for imports &
f.o.b. for exports and
o then multiply this border price expressed in foreign currency by
13 SER to arrive at economic border prices. Wednesday, June 5, 2024
If the commodities are non-traded, i.e.
f.o.b. prices are less than domestic prices & domestic
prices less than c.i.f. prices (f.o.b <d.p< c.i.f).
if the market prices are good estimates of opportunity
cost or willingness to pay:-
o we directly take the market price as economic value of the
item.
However if the prices of non-traded items are distorted:-
o we will adjust the market price to eliminate distortions &
then use these estimates of opportunity cost as the
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The UNIDO method can be summarized as follow.
o Suppose we have a project producing export item that uses
both foreign & domestic inputs.
The net benefit would be estimated as:
o Net benefit= SER(X-M)-D
o Where X - border price of exports in foreign currency
M - Border price of imported goods in foreign currency
D - Adjusted values of domestic goods in domestic
currency
SER - is the shadow exchange rate.
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Where SER=
B. Little-Mirrlees (L-M) approach
In this approach benefits & costs measured at world price to
reflect the true opportunity cost of outputs and inputs.
o It used public saving measured in foreign exchange as the
numéraire (converting everything into its foreign exchange
equivalent).
The fact that:-foreign exchange is taken as a numéraire does not
mean that project accounts are necessarily expressed in foreign
currency.
o The unit of account can remain the domestic Wednesday,
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Valuing output /inputs at world prices (as a measure of economic
benefit) is relate with import substitution policies.
E.G. d/t commercial industries may produce goods at higher
cost than the alternatives available on the international market.
If a project was analyzed at world prices, this would give an
indication:-
First:- whether it could survive in the long term in the face
of international competition, and
Secondly:- whether its output could be obtained more
cheaply from international sources.
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If world prices are used, the economic price at which to value
a project's output is :-
its export price if it adds to exports, or
its import price if domestic production leads to a saving in
imports (import substitution)
Similarly, on the cost side, the price at which to value a project
input is:-
its import price if it has to be imported, or
export price if greater use leads to a reduction in exports.
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The above adjustment applies for traded goods (imported or exported
goods).
o But if the goods or inputs are non-traded goods:- the analyst
needs to use conversion factor to translate domestic prices into
their border price equivalent.
• A conversation factor (CF) is the ratio of the economic
(shadow) price to the market price, that is: CF=
o So the economic price for a non-traded good is its
market price multiplied by the conversion factor.
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In principle, to find the world price of non-traded goods :-
each good could be decomposed into its traded & non-traded
components in the chain of production.
In practice, however, is not feasible to differentiate conversion factors
b/n all non-traded goods b/c the procedure is difficult, time
consuming & costly.
Thus d/t shortcuts which provide reasonable approximation are
needed.
In essence, all the shortcuts involve some degree of averaging
for a group of non-traded items.
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Therefore, some degree of error:- if average or standard
It’s derived as follows :
Where =domestic price in domestic currency
=world price foreign currency
OER= Official exchange rate
= standard conversion factor
o , ( ) is the
shadow exchange rate (SER)i.e., the price of goods in
domestic currency relative to their world prices
=
o ():-is the shadow price of foreign exchange (PF)
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PF=
Where =Weights for the ith commodity
=domestic price of the ith commodity in domestic currency
=world price in foreign currency
PF= shadow price of foreign exchange
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The Little-Mirrlees approach of adjusting domestic prices into
economic prices for a project that produces export goods can
summarize as follows:
Net Present Value (NPV) = OER (X-M) - SCF.D
Where -OER- official exchange rate
X- exported goods in foreign currency
M- imported goods in foreign currency
SCF- standard conversation factor
D- price of non-traded goods in domestic currency
To summarize:- as long as SCF is the ratio of OER to SER, the two
approaches (UNIDO & Little-mirrless) - differ only to the extent that
SER is different from the actual exchange rate
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6.4: Economic Export and Import Parity Price
A. Export Parity Price
C.i.f. at point of import (say, Canada port)
o Deduct- unloading at point of import
o Deduct- freight to point of import (in this case air freight)
o Deduct – insurance
Equals – f.o.b. at point of export (A.A)
Convert foreign currency to domestic currency at official exchange
rate (OER) if you are using the L-M approach or shadow exchange
rate (SER) if you are using UNIDO approach
o Deduct - local port charges
o Deduct - local transport & marketing (if not part of project) at
their economic price and multiply it by SCF in L-M approach
Equals export parity price at project boundary
o Deduct - local storage, transport & marketing costs (if not part of project
cost) at their economic price and multiply it by SCF in L-M approach
Equal economic export parity price at project location (farm gate)
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A parallel computation leads to the economic import parity
price.
Here the issue can be:-
finding the price of project's output that is intended to
substitute previous imports or
the project will use imported inputs.
In either case, the import parity price can be derived as follows.
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B. Import Parity Price
F.o.b. price at point of export
o Add-freight charges to point of import
o Add-insurance charges
o Add- unloading from ship to pier at port
Equals C.i.f. Price at the harbor of importing countries
Convert foreign currency to domestic one (multiply by OER) if you
use L-M approach and SER if you use UNIDO approach
o Add-local port charges
o Add-transport & marketing costs to relevant wholesale market at
economic price & multiply it by SCF in L-M approach
Equal price at wholesale market
o Deduct-local storage & other marketing costs at economic price and
SCF in L-M approach (if not part of project cost) -this is the
marketing margin between central market and the project site.
Equals economic import parity price at project location (Farm / project gate
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price)
6.5. Valuation of non-traded goods
Any output or input whose value to the economy cannot be
measured in terms of f.o.b. or c.i.f. border prices should be
assessed in relation to its price in the home market.
This applies to non-traded commodities, usually those:-
o with high transport costs,
o whose domestic supply prices, at the given level of local
demand, are below the c.i.f. price of imports but above the
f.o.b. price of exports.
It also applies in cases in which government policy isolates
27commodities from foreign markets through import or export
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This price in the home market depends on local conditions of
supply & demand, including :-
Market imperfections,
quantity of input demanded and output supplied;
government intervention of different kinds;
taxes and subsidies that are targeted to compensate
external costs (or benefits) and etc
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As a result of market imperfections or indirect taxes, the
marginal value (demand price) of non-traded inputs or outputs
may differ from their marginal cost (supply price).
The shadow price of such goods may be the demand price, the
supply price, or somewhere in between-depending on whether
project inputs or outputs affect the supply to other users, the
demand from other producers, or both.
To accurately account for both quantity and price effects the
analyst need to assess both the demand and supply side of these
non-traded inputs used and outputs produced by the project.
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6.6:Valuing Externalities
The financial costs of the project will not include the costs
of the externality
Hence, an evaluation of the project based on private
marginal cost (PMC) will
understate the social costs of the project &
overstates its net benefits.
In principle, all we need to do to account for the externality
is
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In practice, the measurement difficulties are tremendous
because
often the shape of social marginal cost (SMC) curve, & hence its r/ship
to PMC curve, is unknown.
also it is not always feasible to trace and measure all external effects.
Nevertheless, an attempt should always be made to identify
them and if they appear significant, to measure them.
When externalities cannot be quantified they should be
discussed in qualitative terms.
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In some cases it is important to “internalize” externalities by
considering a package of closely related activities as one
project - that is, to draw the “project boundary” to include
them.
Drawing the “project boundary” to internalize externality
can be done in two ways:
1) the project can adopt a technology such as pollution
abatement technology that will reduce or avoided
externalities and
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