SOCIAL COST-

BENEFIT
ANALYSIS
SUBMITTED TO DOCTOR GETNET

GROUP MEMBERS
1. WINTA ZENBABAW…..PGRAF/023/07
2. BANTEYIRGU ENGIDA….PGRAF/003/07
3. MIZANU DEMESSIE……..PGRAF/017/07
Introduction
Social cost-benefit analysis a systematic approach to estimating the strengths and
weaknesses of alternatives that satisfy transactions, activities or functional requirements for a
business. It is a technique that is used to determine options that provide the best approach for the
adoption and practice in terms of benefits in labor, time and cost savings. Social cost-benefit
analysis (SCBA), is a methodology developed for evaluating investment projects from the point
of view of the society or economy as a whole. Although economic analysis can be applied to
both profit oriented (private) projects and public investments, it is primarily used for evaluating
public investments.
The SCBA is also defined as a systematic process for calculating and comparing benefits and
costs of a project, decision or government policy. Broadly, SCBA has two purposes:

1. To determine if it is a sound investment/decision

2. To provide a basis for comparing projects.

It involves comparing the total expected cost of each option against the total expected
benefits, to see whether the benefits outweigh the costs, and by how much.
Scope of SCBA is used primarily for evaluating public investments. It has received a
growing importance in many countries mainly in developing countries. SCBA links specific
projects with broader strategies and national objectives….
Since private investments get approval from the government and quasi-governmental
agencies, economic analysis is applied to private investments. Social cost-benefit analysis helps
in evaluating individual projects within the planning framework, which indicates national
economic objectives and broad allocation of resources to various sectors. In other words, it is
concerned with tactical decision-making within the framework of broad strategic choices defined
by planning at the macro level. The perspectives and parameters provided by the macro level
plans serve as the basis of economic analysis. These perspectives and parameters are considered
as tools for analyzing and appraising individual projects.
 Financial analysis focuses on monetary costs and benefits of the project whereas
economic analysis focuses on the social costs and benefits of the project; which are mainly
concerned with commercial profitability and economic analysis respectively. There are some
major principles that make monetary costs & benefit and social cost & benefits differ from one
another.

1. Market imperfections
In computing the monetary costs and benefits, market prices are the prime base.
Market prices show social values only under conditions of perfect competition on the
view point of a private investor. However, in developing countries, markets are not
perfect and as a result imperfections occur. When imperfections exist, market prices do
not show social values. The common market imperfections are:
a) Rationing
b) Prescription of minimum wage rate
c) Foreign exchange regulation

2. Externalities
Externalities refer to the external benefits or costs that the project creates and for which
the users do not pay or get compensation. For example, a project may create infrastructure
facilities like roads. These roads benefit the neighboring areas. Financial analysis ignores such
benefits in assessing the project because the owners of the project do not receive any monetary
compensation from those who enjoy this external benefits created by the project. Similarly, a
project may have a harmful effect such as pollution of the environment. Financial analysis does
not take into account such harmful effect of the project. However, in economic analysis, all costs
and benefits of the project are relevant irrespective of whom they accrue and whether they are
paid for or not.
 3. Concern for savings
In evaluation of private investments, the division of benefits between consumption and
savings is not made. In other words, private investments do not put differential valuation on
savings and consumption. From social point of view, it is relevant to divide the benefits between
consumption and savings. It is generally believed that a Birr benefit saved is deemed to have
more value than a Birr benefit saved. This means a higher valuation is placed on savings and a
lower valuation is put on consumption. Thus, economic analysis of the project reflects the
concern of the society for savings as well as investments.

4.Taxes and Subsidies

From financial analysis point of view, taxes are definite monetary costs and subsidies
are definite monetary gains. An example of subsidy is tax exemption (holiday) granted by the
government. From the social point of view, taxes and subsidies are generally regarded as transfer
payments. Thus, taxes and subsidies are irrelevant for economic analysis.

5.Merit wants
Merit wants refer to goals and preferences that are not expressed in the market place.
These goals and preferences are believed by policymakers to be in the larger interest. For
example, the government may prefer to promote girls education. This is not sought by consumers
in the market place. Merit wants are not relevant from the private point of view. But they are
important from the social point of view.

6. Concern for Redistribution

Different groups in the society get benefits from the project. A private firm does not
bother how its benefits are distributed across various groups. However, the society is concerned
about the distribution of benefits across different groups. This is based on the assumption that a
Birr of benefit going to an economically poor section is considered more valuable than a Birr of
benefit going to an affluent (rich) section of the society. Thus, economic analysis of the project is
concerned with the redistribution of the benefits from the project.

Approaches to social cost-benefit analysis

There are two approaches to SCBA

1. UNIDO Approach
2. Little and James Alexander Mirrlees (L–M) Approach (Border price approach )
They have both similarities and also differences

UNIDO Approach
The United Nations Industrial Development Organization (UNIDO) method of the project
appraisal involves five stages. These are:
1. Calculation of the financial feasibility of the project measured at market prices (Financial
Analysis of the Project).
2. Obtaining the net benefits of the project 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 redistribution.
5. Adjustment for the impact of the project on merit goods and demerit goods whose social
values differ from their economic values.

The first stage is a calculation of the financial profitability of the project that is measured at
market prices.
The second stage of UNIDO approach is concerned with the determination of the net benefits of
the project in terms of economic, efficiency, or shadow prices. In perfect markets, market prices
represent shadow prices. But when there is market imperfection, market prices do not represent
shadow prices and hence there is a need to develop shadow prices that is used to determine net
economic benefits of the project.
Before dealing with shadow pricing of specific resources, it is desirable to discuss the basic
concepts and issues. Some of the basic issues include:

A) Choice of Numeraire
Numeraire refers to the unit of account in which the value of inputs or outputs is expressed. To
define numeraire, the following questions have to be answered.
- What unit of currency (domestic or foreign) should be used to express benefits and costs?
- Should costs and benefits be measured in current values or constant values?
- With references to which point (present or future) should costs and benefits be evaluated?
- What use (consumption or investment) will be made of the income from the project?
- Should income of the project be measured in terms of consumption or investment?
- With reference to which group should the income of the project be measured?

The specification of the UNIDO Numeraire in terms of the above questions is: “Net present
consumption in the hands of people at the base level of consumption in the private sector in
terms of constant price in domestic accounting Birr.”

B) Concepts of Tradability
Whether a good is tradable or not is the key issue in shadow pricing. The international price is a
measure of its opportunity cost to the country for tradable goods. For tradable goods, it is
possible to substitute import for domestic production and vice versa. Likewise, it is possible to
substitute export for domestic consumption and vice versa. Thus, the international price (also
called the border price) represents the real value of the goods in terms of economic efficiency.

C) Sources of shadow prices

A project uses and produces resources. A project may for any given input or output:
i. Increase or decrease the total consumption in the economy
ii. Increase or decrease production in the economy
iii. Increase or decrease imports, or
iv. Increase or decrease exports
According to UNIDO, there are three sources of shadowing pricing; namely,
1. Consumer willingness to pay – used if the impact of the project is on consumption in the
economy
2. Cost of production – used if the impact of the project is on production in the economy.
3. Foreign exchange value – used if the impact of the project is on international trade. How
project affects international trade? The project may increase/decrease imports or exports.

D) Taxes
When shadow prices are being calculated, taxes usually pose difficulties. With respect to taxes,
UNIDO’s guidelines are as follows:
1. Include taxes in shadow pricing – when a project results in diversion of non-traded inputs,
which are in fixed, supply from other producers or addition to non-traded consumer goods.
2. Exclude taxes from shadow pricing – when a project augments domestic production by other
producers. Taxes should also be excluded from shadow pricing for fully traded goods.

Shadow Pricing of Specific Resources

1. Shadow pricing for tradable inputs and outputs

A good is fully traded when an increase in its consumption results in a corresponding increase in
import or decrease in export or when an increase production results in a corresponding increase
in export or decrease in import. For such goods, shadow pricing is the border (international)
price translated into domestic currency at the market exchange rate.
For fully traded goods, domestic changes in demand or supply affect just the level of imports or
exports. The following conditions should be met for imported goods to be traded.

a) If there is an import quota, goods are not restrictive

b) The import supply is perfectly elastic over the relevant range of import volume
c) There is no surplus domestic capacity, it cannot be utilized for want of necessary inputs.
d) If the additional demand exists in land, the imported goods cost less than the marginal
cost of production.
 e) The imported input costs less than the domestic marginal cost of purchase.

When the above conditions are met, additional demands are satisfied by external trade. Similar
conditions must be satisfied for importable outputs, exportable inputs, and exportable outputs

2. Shadow pricing for non-tradable inputs and outputs

For non-tradable goods, the border price does not reflect its economic value. More
specifically, a good is said to be non tradable when the following conditions are satisfied:

a) Its import price is greater than its domestic cost of production.

b) Its export price is less than its domestic cost of production.

3. Shadow pricing for externalities

Externalities are special classes of goods. Externalities have the following characteristics:

1.They are not deliberately created by the project owners but are incidental outcome of the
economic activity.
2.They are beyond the control of the persons who are affected by them, for better or for worse.
3.They are not traded in the market and thus have no market price. Externalities may be
beneficial or harmful. They are intangible in nature.

The values of externalities are estimated by indirect means. For example,

Let us assume that the company designed a training project that helps
upgrade the skills of its workers thereby enhancing their earning power in
subsequent employments. From this description of the project, the beneficial
external effect is the enhancement of employees earning power in
subsequency employment. What is the value of this benefit? The benefit
from the training programme may be estimated in terms of increased earning
power of workers.
Generally, it is not easier to measure external effects (or externalities). Due to this, some argue
that these external effects should be ignored. Other suggested that external effects should be
taken into consideration whenever it is possible to do so. Although these effects cannot be
measured in monetary terms, some qualitative evaluation must be attempted.

4. Shadow pricing for labour inputs

Labour is considered to be a service. The principles of shadow pricing for goods may be
applied to labor as well.

When a project lives a labour, it could have three possible impacts on the rest of the economy.

i. It may take labour away from other employment

ii. It may induce the production of new workers
iii. It may involve import of workers

When a project takes labor away from other, the shadow price of labour is equal to what other
users of labor are willing to pay for this labor. This will be equal to the marginal product of such
labor in a relatively free market.

The social cost associated with inducing ‘additional’ production of workers consists of the
following:

a) The marginal product of the worker in the previous employment. For unemployed worker,
marginal product is equal to zero.
b) The value assigned by the worker on the leisure that he may have to forgo as a result of
employment in the project. The value of this leisure is reflected in his reservation wage
which depends on:
- The income a person already enjoys through transfer payments
- His/her idea of what job is acceptable to him/her.
- His/her preference for work and leisure.
 c) The additional consumption of food when a worker is fully employed as opposed to when
he/she is idle or only partly employed.
d) The cost of transport and rehabilitation when a worker is moved from one location to
another.
e) The increased consumption by the worker and its negative impact on savings and
investments.
f) The cost of training a worker to upgrade his/her skills.

The social cost associated with the import of foreign workers is the wage they command.

5. Shadow pricing for capital inputs

Capital inputs refer to investments in machinery, building, and other similar physical
assets. Two things happen when a capital investment is made in a project. There are:

A) Financial resources are converted into physical assets

The value (shadow price) of physical assets is calculated the way the value of other
resources is calculated. If it is a fully traded good, its shadow price is equal to its international
price. The cost of production or consumer willingness to pay becomes the basis of shadow price
for non-traded goods.

B) Financial resources are withdrawn from the national pool of savings and hence alternative
investments are foregone
These financial resources involve opportunity cost. The opportunity cost of capital
depends on how the capital required for the project is generated. To the extent that it comes from
additional savings, its opportunity cost is measured by the consumption rate of interest. The
consumption rate of interest reflects the price the saver must be paid to sacrifice present
consumption. To the extent that it comes from the denial of capital to alternative projects, its
opportunity cost is the rate of return that would be earned from those alternative projects (also
called the investment rate of interest).
6. Shadow pricing for foreign exchange
According to UNIDO, the Numeraire is the domestic currency (Birr). Thus, the
foreign exchange input of the project must be identified and adjusted by an appropriate premium.
The valuation of inputs and outputs that was measured in international price (Birr) has to be
adjusted upward to reflect the shadow price of foreign exchange.

The shadow price of foreign exchange is determined on the basis of marginal social
value. The marginal social value is revealed by the consumer willingness to pay for the goods
that are allowed to be imported at the margin. The shadow price (value of unit of foreign
exchange is equal to:
n
∑ F i Qi Pi
i=1

Where:
Fi = Fraction of foreign exchange, at the margin, spent on importing commodity i.
Qi = Quantity of commodity i that can be bought with one unit of foreign exchange
1
Qi = CIF
CIF = Cost, Insurance, Freight
Pi = Domestic market clearing price of commodity i.
Let us assume that commodity 1, commodity 2 and commodity 3 are imported at margin. The
proportion of foreign exchange spent on them, the quantities that can be bought per unit of
foreign exchange, and the domestic market clearing prices are as follows:
F1 = 0.4 F2 = 0.3 F3 = 0.3
Q1 = 0.8 Q2 = 1.2 Q3 = 4
P1 = 20 P2 = 10 P3 = 15
The value of a unit of foreign exchange is computed
As follows:
n
∑ F i Qi Pi
Since the shadow price formula is i=1 :

Value = (0.40 x 0.8 x 20) + (0.3 x 1.2 x 10) + (0.3 x 4 x 15) = Br. 28
Impacts on distribution of income and savings
In case of monetary cost benefit analysis a private firm is least concerned as to
how its benefits are divided between consumption and savings, but from social point of view,
however, the division of benefit between saving and consumption is relevant because while
doing SCBA it is assumed that a rupee of benefit saved is more valuable than a rupee of benefit
consumed. Thus a higher concern of society for saving and investment is duly reflected in SCBA
where higher valuation is put on saving than on consumption
-: while doing monetary cost and benefit analysis a private firm is least concerned about as to
how its benefits are being distributed among various groups of the society, but while doing
SCBA this factor is kept in mind because it is assumed that a rupee of benefit going to the poor
section is considered more valuable than a rupee of benefit going to an affluent section

Adjustment for Merit and Demerit Goods

A merit good is one for which the social value exceeds the economic value. For instance a
country may place a higher social value than economic value on production of oil because it
reduce dependence on foreign supplies. In case of demerit good the social value is less than
the economic value. For e.g. Alcoholic products.
The method of adjusting for the difference between social value and economic value is as
follow -:
 Estimate the economic value
 Calculate the adjustment factor as the difference between the ratio of social value
to economic value and unity.
 Multiply the economic value with the adjustment factor to obtain the adjustment
 Add the adjustment to net present value of the project.

A merit good could be oil, and creation of employment. A higher social value may be placed
over economic value on production of oil by the country because it reduces dependency on
foreign suppliers.
A Demerit good is a good whose economic value exceeds social value. Some of the best
examples of demerit goods are tobacco products, and alcoholic products

In order to adjust for merit or demerit goods, the following steps may be used:
1. Estimate the economic value of the project
2. Calculate the adjustment factor
Social value
−1
Adjustment factor = Economic value
For merit goods, the ratio of social value to economic value is greater than 1 and adjustment
factor becomes positive. On the other hand, the ratio of social value to economic value is less
than 1 for demerit goods and the adjustment factor becomes negative.

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

Adjustment = Economic value x adjustment factor
4. Compute the social value by adding adjustment to the economic value
Social value = Economic value  Adjustment
Illustration. The adjustment for the difference between social value and economic value of the
project, assume that the present economic value of the project is Br. 5,000,000. The output of the
project is merit good and its social value exceeds its economic value by 30%.

Based on the above information, the adjustment factor is computed as follows:

130 %
−1
Adjustment factor = 100 %
= 1.30 - 1
= 30%
Adjustment for merit good is computed as follows:
Adjustment = Economic value X adjustment factor
= 5,000,000 X 0.30
= 1,500,000
Then social value is equal to the sum of economic value and adjustment
Social value = 5,000,000 + 1,500,000 = 6,500,000
 LITTLE AND MIRRlEES APPROACH
The seminal work of Little and Mirrlees on social benefit-cost analysis systematically
develops a theoretical basis for the analysis and its underlying assumptions and lays down step-
wise procedure for undertaking benefit-cost studies of public projects. The mathematical
formulation is identical to the UNIDO method except for differences in assigning value to
discount rates and accounting for imperfections and other market failures and social
considerations of investment from different angles.
Little and Mirrlees procedure is relatively more practical, although, unlike guidelines, it does not
provide sufficient insights by examining project. Various approaches were developed to view
considerations on focus of efficiency, savings and re- distribution.

a. Shadow price of traded goods

.The
The border price is considered the shadow price for a traded good or service. Assume
that foreign demand and supply are perfectly elastic, the shadow price of exportable
goods is Free-on-Board (FOB) price. On the other hand, the shadow price of importable
good is its Cost Insurance Freight (CIF) price.

b. Accounting price of non-traded goods

Certain goods are not amenable to foreign trade, such as land, building, electricity,
water, and transportation. Since there is no observable border price for such goods and services,
their shadow (accounting) prices are defined in terms of marginal social cost and marginal social
benefits.
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. Similarly, the marginal social benefit is the value
of an extra unit of the good from the social point of view.