Economic and Social Cost Benefit Analysis

Dr. Tarun Das, Professor (Public Policy),

IILM, New Delhi-110003, India.
EMAIL: tarun.das@iilm.edu/ das.tarun@hotmail.com

1. Introduction

The starting point of a pre-project evaluation is to make a technical feasibility study by

the engineers and other technical experts to examine whether the project is technically
sound. The technical team then specifies the technical details for the project for its project
specification, implementation and maintenance over time. After examining the technical
feasibility of a project, it needs to be examined whether the project is financially viable,
economically sustainable and socially (or environmentally) desirable. Accordingly, there
are four basic techniques for the pre-evaluation of a project and a Detailed Project Report
(DPR) by any lead investment bank must include the following methods depending on
the purpose of the project, the methods for project financing, policies for recovering of
costs and fixing of charges from the users:

(a) Technical feasibility analysis;

(b) Financial cost-benefit analysis;
(c) Economic cost-benefit analysis and
(d) Social (or environmental) cost-benefit analysis.

This paper focuses on the financial, economic and social cost-benefit appraisal
techniques.

Financial cost-benefit analysis

The traditional financial cost-benefit analysis deals with actual financial transactions and
makes orthodox commercial analysis on the basis of market prices of products and all
factors of production. It does not deal with the questions of distributional equity and does
not make an analysis of the impact of externalities. The financial analysis generally
estimates the cost/ benefit ratio (CBR), net present value of benefits (NPV) and the
Internal Rate of Return (IRR). Financial viability conditions require that CBR<1,
NPV>0, IRR>PLR where PLR is the prime lending rate charged by the funding agencies.

Table 1.1: Project Evaluation Criteria:

Year Cost Benefit Present value of cost Present value of benefit
1 C1 B1 C1/(1+r)¹ B1/(1+r)¹
2 C2 B2 C2/(1+r)² B2/(1+r)²
3 C3 B3 C3/(1+r)³ B3/(1+r)³
… … … … …
a Ca Ba Ca/(1+r)ª Ba/(1+r)ª
Total ∑Ca ∑Ba ∑Ca /(1+r)ª ∑Ba /(1+r)ª

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1. Benefit/Cost Ratio (BCR) = ∑Ba /(1+r)ª / ∑Ca /(1+r)ª
2. NPV = ∑Ba /(1+r)ª - ∑Ca /(1+r)ª
3. Internal Rate of Return (IRR) is the value of r at which the PV of benefits equals
the PV of Costs or NPV = 0 i.e. ∑Ba /(1+r)ª = ∑Ca /(1+r)ª

Economic cost-benefit analysis

In the economic cost-benefit analysis, instead of market prices, the appraisal is based on
the economic costs or the resource costs or opportunity costs of both of the factors of
production and the outputs. This is done on the basis of the following two adjustments in
the financial cost-benefit analysis:

(i) All costs are netted out of all indirect taxes and duties and subsidies.

(ii) The scarce and surplus factors are shadow priced. In general, one attaches shadow
prices to labour, energy and foreign exchange cost to take care of their either scarcity
values or slack values. Shadow prices for scarce items (i.e. items with excess demand
such as energy, foreign exchange and skilled labor) will have shadow prices higher
than their market prices, whereas items with excess supply (for example unskilled
labour) will have shadow prices lower than their market prices.

(iii) Some examples of shadow prices in India:

(1) Border prices for tradable items (fob price for exportable items and CIF
price for importable items)
(2) 0.80 for unskilled and 1.20 for skilled labor
(3) Black-market rate (1.05) for foreign exchange
(4) 1.20 for energy and non-renewable natural resources

Social cost-benefit analysis.

Social cost benefit analysis goes further beyond the financial and economic cost-benefit
analysis, and deals with not only efficiency pricing but also takes care of distributional
equity and impact of externalities on the project.

The two most prominent methodologies, which address these issues in a systematic way,
are the UNIDO (1972) and Little Mirrelees (1968, 1974) book on projects appraisal.
Continual discussions and debates on these two approaches have led to a vast literature
on refinements and synthesis of techniques, and more sophistication in comparison with
the conventional commercial profitability analysis.

Table 1.2 below summarizes the basic differences in these three types of cost-benefit
analysis and Annex-1 provides a numerical example for a road construction project. It
may be particularly noted that the impact of externalities and indirect costs and benefits
are not considered under financial and economic cost-benefit analysis, but are considered
for social cost benefit analysis. Major social and environmental costs include costs for

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pollution control, public health, safety, security, environmental degradation (soil erosion,
deforestation), costs for rehabilitation, retraining etc. Major social and environmental
benefits include reduction of poverty through income rise, rise in longevity, increase of
prices of land, houses, crops etc.

For example, for a road construction project, external costs may include costs due to
pollution, accidents, traffic police, street lighting, rehabilitation of displaced people, cost
of deforestation, if any, etc.; whereas external benefits will include rise of income,
property and commodity prices in the hinterland area due to better mobility of workers
and enhanced accessibility of agricultural lands and adjacent regions to the commodity
markets and urban areas.

Table 1.2 Differences in Financial, Economic and Social cost-benefit appraisal

Items Financial Economic Social

1. Project costs Actual financial costs Some items are shadow Some items are shadow
priced priced
2. Project benefits Actual financial Some items are shadow Some items are shadow
benefits priced priced
3. Indirect taxes, Are taken into account Are excluded Are excluded
duties, subsidies
4. Shadow prices Not used Used Used
5. Externalities Not considered Not considered Considered

Table 1.3: Criteria for Acceptance of Project

Criteria Financial Economic Social

1. Benefit/ cost BCR >1 BCR >1 BCR >1

ratio (BCR)
2. Net Present NPV > 0 NPV > 0 NPV > 0
Value (NPV)
3. Internal Rate of Financial IRR > PLR Economic IRR > 6 Social IRR > 12
Return (IRR) (Prime lending rate) (Real rate of interest or (Social rate of
real GDP growth) discounting)

2. Project Appraisal Techniques

Given limited public resources and competing sectors needing public funds, it is
necessary to make a comprehensive analysis of social costs and social benefits of a
project and to bring its coherence to the list of investment projects. What is needed for
that is a technique that would rank projects in order of their economic desirability, so that
they could be adopted in rank order until the investment budget is exhausted.

Previously, development economists had argued the merits of different criteria for
deciding on project investment - the degree of capital intensity, the rate of reinvestment,

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the internal rate of return, the cost/benefit ratio, the size of the externalities and so on.
The integration of these various investment criteria within a single procedure of appraisal
of net present value was the work of Little and Mirrlees.
A major issue of project appraisal is to measure the true cost of transferring a marginal
unit of rural labour to urban employment, rather than assuming (as Lewis did) that the
transfer is costless. At the same time, the valuation of a project’s non-labour inputs and
outputs also pose difficult problems. They are due to the interventions by the
governments that affect price formation in both rural and urban areas. For example,
procurement of foodgrains at minimum support prices by the government of India pushes
up market prices, while supply of subsidized foodgrains through ration shops of fair price
shops puts downward pressure on market prices.

Constraints of social cost-benefit appraisal

Determination of market price is a complex issue. In any case, they are deviations from
the market-clearing prices in a perfectly competitive market, as the real markets are
neither perfect nor competitive. These deviations are referred to as price distortions due
to market imperfections, but the idea of a price distortion makes sense only relative to
some standard of undistorted prices. Little and Mirrlees proposed ‘world prices’ as their
‘sheet anchor’, but there are skepticisms among the economists, as there is no single
“world price”. However, the use of world prices as a norm makes a significant shift in
economic thinking about development.

Moreover, there is a more fundamental problem. The SCBA technique is an attempt to

use ‘shadow’ prices to select investments, that is, to invest as if free market prices ruled,
when in fact they do not. If the market ruling prices are not based on the principles of
shadow pricing, then the outcome will not be realized.

It is well known that perfect competitions is a utopia and does not exist in reality. As
mentioned earlier, the real markets are neither competitive nor perfect. Investments
chosen on the basis of economic costs or resource cost would not necessarily be
financially viable unless the existing prices are determined by the economic costs. This
implis that the survival of the projects would depend either on the government’s
continuing ability to give them subsidies, a condition that becomes more difficult as the
politico-economic turbulence has unfolded recently in many parts of the world. The
alternative and the recommended option for the government is to dismantle the
interventions that prevent projects from being profitable and to make suitable public
policies that attract private investment including foreign investment for project funding
on the basis of market determined and rational prices for inputs and outputs..

To give an example, in the middle of 1980s, the present author built a multi-regional
multi-sectoral multi-modal transport-planning model for the Planning Commission of
India on the basis of economic costs where labor, foreign exchange and energy costs
were shadow-priced. Financial wage costs for unskilled labor were reduced by 20
percent, while energy costs were enhanced by 20 percent and foreign exchange costs
were enhanced by 25 percent (i.e. shadow price of labour was taken as 0.8, and shadow

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price of energy as 1.2 and shadow price of foreign exchange as 1.25). Then the economic
cost was estimated for both rail and road by adding operator’s costs and user cost’s.

On the basis of economic cost, road transport cost was observed to be lower than the rail
transport cost for short distance, while rail transport had comparative advantage for long
distance. The distance at which road looses its comparative advantage for transport of
goods and passengers is called “break even point”.

Figure-2.1: An Example of Break-Even Point Between Rail and Road-

nsport Cost (Rs)

Table-2.1: Break Even Points for Roads (kilometers)

400
Goods Road Average BE Point (KM) BE Point (KM) % shift of
Lead (kms) 1976-77 price 1986-87 price BE Point
Food-grains 386 247 280 +13.4
Coal 469 201 232 +15.4
Iron ore 373 241 324 +34.4
POL
Iron-steel
Cement
271
487
276
60
311
222
67
220
193
300
+10.1
-29.3
-13.1
Fertilizers 292 200 184 -8.0
All goods 406 200 210 +5.0

200
Note: Break-even point is the distance at which road looses its comparative advantage in
terms of unit transport cost for the movement of specific commodities.

The transport model calibrated on the basis of economic costs of transportation for rail
and road led to the following conclusions:

100
1. Rail transport is least expensive for long and medium distance and bulk traffic.

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 2. Rail transport is least energy intensive, more environment friendly and less
accident prone than road transport.
3. Road transport is the cheapest mode for short distance and consumer friendly for
door to door service. It also generates more employment and helps in enhancing
rural connectivity and reducing poverty.
4. However, road transport is more energy intensive and leads to pollution problems
and traffic hazards.

On the basis of economic costs for transporting goods and passengers, modal shares for
rail and road were projected for future, and required capacity expansions and transport
investments were estimated by the model. It was recommended that rail should have a
share of 75 percent in total goods and passenger traffic.

However, due to political economy constraints, rail passenger fares and freight rates for
goods traffic were kept low as compared their economic costs, and the projected rail
corridors were not expanded or upgraded. As a result, over the years, actual modal shares
became completely reverse resulting in irrational and non-optimal modal shares.
Presently, roads account for 75 percent traffic for both passengers and freight and rails
account for only 25 percent of traffic resulting in huge loss of economic resources.

3. Identification of Benefits and Costs

In social cost benefit analysis, the most important and the most difficult task is to identify
and measure all social costs and benefits associated with the projects. These costs and
benefits arise due to externalities of the project. They relate to local resources, eco-
system and overall environment. While the technical feasibility and the financial viability
excercises are well developed and there are conventional methods to conduct those
studies, economic and social cost-benefit analysis depend on the purpose of the studies.

The social cost benefit appraisal procedure for projects is very complex, even with short
cuts. Moreover, no procedure can preclude opportunities for manipulating the numbers to
give the result that political masters would like to have on non-economic considerations.
In practice, the social cost-benefit appraisal techniques are scarcely more successful that
the financial cost benefit analysis or economic appraisal of projects.

Let me discuss these problems in relation to two project reports submitted to the Ministry
of Rural Development, which I had a chance to look at.

4. Evaluation of Poverty Alleviation Programs

Growth with social justice and alleviation of poverty have been primary objectives of
Indian planning since its inception in 1951. Several anti-poverty programs have been in
operation for decades focussing the poor as the target groups. These include programs for
the welfare of weaker sections, women and children, and a number of special
employment programs for self- and wage employment in rural and urban areas. The

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ongoing economic reforms since 1991 have also a human face and attached high priority
to the development of social sectors.

The government has relied mainly on two approaches for poverty alleviation: the first
based on the anticipation that economic growth will have a “trickle down effect” on the
levels of living of all groups in society; and the second that direct anti-poverty programs
are also required. More recently, government shifted public expenditure away from
investment in infrastructure and industry towards social sectors, and improved targeting
of subsidies through changes in the public distribution system.

Anti-poverty programs have been strengthened over the years to generate more
employment, create productive assets, impart technical and entrepreneurial skills and
raise the income level of the poor. But most evaluations - whether done by the
government or others - agree that these programs have not been very effective in reducing
poverty, as these suffer from ill-defined multiple objectives, limited targeting towards the
poor, under-funding and often complex administration, high administrative costs and
leakage, lack of proper accountability and adequate monitoring.

For example, a recent study of the Public Distribution System (PDS) suggested that as
little as 25 per cent of the foodgrains actually reach the poorest 40 per cent of the
population and that administrative costs far outweigh the income gains to the poor. In
general, it costs the government between 2 and 7 rupees (with the highest value reported
for the PDS) to provide one rupee to the poor. One of the better-targeted programs is the
Integrated Child Development Services (ICDS). Similarly, public works have been
relatively more successful at targeting the poor and have improved significantly the living
standards of a large number of poor at a relatively low cost.

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 Annex-1
A Numerical Example for Financial, Economic and Social Cost Benefit Analysis
Of a Road Construction Project connecting hinterland to a sea port
(In millions of Indian Rupees)

Costs per year Financial Economic Social

A. Project cost
Rupee cost 504 450 450
-- Basic price 450 450 450
-- Excise duty 54 0 0
Foreign exchange 220 210 210
-- Basic price 200 210 210
-- Import duty 20 0 0
Total project cost 724 660 660
B. Operating cost
Skilled labor 60 72 72
Unskilled labor 200 160 160
Energy 100 120 120
Foreign exchange 70 73.5 73.5
Indirect taxes 200 0 0
Less Subsidies (-) 40 0 0
Others 410 410 410
Total operating cost 1000 835.5 835.5
C. Social costs 0 0 150
D. Benefits
-- Domestic sales 900 900 900
-- Exports 300 315 315
Export duty (-) 50 0 0
Social benefits 0 0 500
Total benefits 1150 1215 1715

Additional Social Benefits and Costs due to externalities

E. Indirect cost
Policing 50
Environment 50
Basic health 50
Total 150
F. Indirect benefits
Rise of individuals income 150
Rise of land and housing prices 150
Rise of crop price 200
Total 500

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Financial Cost-Benefit Analysis r= 10
Year Benefits Costs Dis.Bnft Dis.Cst
1 504 0 458.2
2 220 0 181.8
3 1150 1000 864.0 751.3
4 1150 1000 785.5 683.0
5 1150 1000 714.1 620.9
6 1150 1000 649.1 564.5
7 1150 1000 590.1 513.2
8 1150 1000 536.5 466.5
Total 4139.3 4239.4
BCR = 0.98 NPV = -100.1

Financial Cost-Benefit Analysis r= 5.415

Year Benefits Costs Dis.Bnft Dis.Cst
1 504 0 478.1
2 220 0 198.0
3 1150 1000 981.7 853.7
4 1150 1000 931.3 809.8
5 1150 1000 883.5 768.2
6 1150 1000 838.1 728.8
7 1150 1000 795.0 691.3
8 1150 1000 754.2 655.8
Total 5183.8 5183.7
IRR = 5.415 NPV = 0.1

Financial IRR equals 5.415, NPV is negative and BCR (Benefit/Cost Ratio) is less
than unity. So the project is not financially viable, unless the government provides
financial support to the project.

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Economic Cost-Benefit Analysis r= 10
Year Benefits Costs Dis.Bnft Dis.Cst
1 450 0 409.1
2 210 0 173.6
3 1215 835.5 912.8 627.7
4 1215 835.5 829.9 570.7
5 1215 835.5 754.4 518.8
6 1215 835.5 685.8 471.6
7 1215 835.5 623.5 428.7
8 1215 835.5 566.8 389.8
Total 4373.3 3589.9
BCR = 1.22 NPV = 783.3

Economic Cost-Benefit Analysis r= 39.13

Year Benefits Costs Dis.Bnft Dis.Cst
1 450 0 323.4
2 210 0 108.5
3 1215 835.5 451.1 310.2
4 1215 835.5 324.3 223.0
5 1215 835.5 233.1 160.3
6 1215 835.5 167.5 115.2
7 1215 835.5 120.4 82.8
8 1215 835.5 86.5 59.5
Total 1382.9 1382.9
IRR= 39.13 NPV = 0.0

Economic IRR turns out to be very high at 39.13, BCR=1.22 and NPV=783. So the
project is economically viable. Govt can provide financial support and can recover
the funds through suitable taxation and pricing policies.

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Social Cost-Benefit Analysis r= 10
Year Benefits Costs Dis.Bnft Dis.Cst
1 450 0 409.1
2 210 0 173.6
3 1715 985.5 1288.5 740.4
4 1715 985.5 1171.4 673.1
5 1715 985.5 1064.9 611.9
6 1715 985.5 968.1 556.3
7 1715 985.5 880.1 505.7
8 1715 985.5 800.1 459.7
Total 6173.0 4129.8
BCR= 1.5 NPV= 2043.1

hSocial Cost-Benefit Analysis r= 46.31

Year Benefits Costs Dis.Bnft Dis.Cst
1 450 0 323.4
2 210 0 108.5
3 1715 985.5 547.6 365.9
4 1715 985.5 374.3 263.0
5 1715 985.5 255.8 189.0
6 1715 985.5 174.8 135.9
7 1715 985.5 119.5 97.7
8 1715 985.5 81.7 70.2
Total 1553.6 1553.6
IRR = 46.31 NPV = 0.0
Social rate of return is also substantially high at 46.31%. So the government can
provide financial support and can recover the funds through imposing additional
taxes on the beneficiaries of the road project, as well as by imposing “filth tax or
pollution tax” on the road users.

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