Cost-Benefit Analysis

- “ to describe and quantify the social advantages and

disadvantages of a policy in terms of a common monetary
unit”

Evaluation on the basis of Benefits

Benefit refers to the addition to the flow of national output

occurring from a project.

‰ Real and Nominal Benefits

‰ Direct and Indirect Benefits

‰ Tangible and Intangible Benefits

Evaluation on the basis of Costs

‰ Project Cost

‰ Associated costs

‰ Real and Nominal Costs

‰ Primary or Direct Costs

‰ Indirect or Secondary Costs

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 Social Cost Benefit Analysis (SCBA)

- Economic analysis
- A methodology developed for evaluating investment projects
from the point of view of the society (or economy) as a
whole.
- Used primarily for public investment

‰ SCBA aids in evaluating individual projects

o Spells out broad national economic objectives
o Allocation of resources to various sectors

‰ SCBA is concerned with tactical decision making within the

framework of broad strategic choices defined by planning at
the macro level.

Rationale for SCBA

• Focuses on the social cost and benefits of the project

• Principle sources of discrepancy:
o Market Imperfection
o Externalities
o Taxes and Subsidies
o Concern for Savings
o Concern for redistribution
o Merit Wants

Market Imperfection

‰ Market prices reflect social values only under condition of

perfect competition (which are rarely realized by developing
countries)

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Common sources of market imperfection in developing countries:
i. Rationing
ii. Prescription of minimum wage rate
iii. Foreign exchange regulation

Externalities

ƒ External benefit or cost created by the project

ƒ Not usually included in the financial cost benefit analysis of
the project
ƒ In SCBA all external costs and benefits, irrespective to whom
they accrue and whether they are paid for or not, are relevant

Taxes and Subsidies

From private point of view:

ƒ Taxes are monetary costs
ƒ Subsidies are definite monetary gains

From social point of view taxes and subsidies are generally

regarded as transfer payments and hence considered irrelevant.

Concern for Savings

ƒ Parts of benefit saved is deemed more valuable than the part

of benefits consumed
ƒ In SCBA higher valuation is placed on savings and a lower
valuation is put on consumption

Concern for redistribution

ƒ A taka of benefit going to an economically poor section is

considered more valuable than a taka of benefit going to an
affluent section

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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.

UNIDO Approach

Two principle approach for SCBA:

- UNIDO Approach
- Little-Mirrlees Approach

UNIDO method involves five stages:

1. Calculation of financial profitability measured at market

prices
2. Obtaining the net benefit of the project measured in terms of
economic (efficiency) prices
3. Adjustment for the impact of the project on savings and
investment
4. Adjustment for the impact of the project on income
distribution
5. Adjustment for the impact of the project on merit goods and
demerit goods

Net benefit in terms of Economic (Efficiency) prices:

- Also referred to as shadow prices

- Market prices represent shadow prices only under conditions
of perfect markets
- So, shadow prices need to be developed and economic
benefit need to be measured in terms of these prices

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Shadow Pricing

Choice of Numéraire
ƒ the unit of account in which the value of inputs or outputs is
expressed
o What unit of currency (domestic or foreign)?
o Current values or constant values?
o With reference to which point – present or future?
o In terms of consumption or investment?
o With reference to which group?

UNIDO Numéraire: “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 unit.”

Concept of Tradability

ƒ For tradable goods, the international price is a measure of its

opportunity cost to the country
o Substitute import for domestic production and vice
versa
o Substitute export for domestic consumption and vice
versa
Hence, the international price, also referred to as the border price,
represent the ‘real’ value of the good in terms of economic
efficiency.

Tax

Sources of Shadow Prices

UNIDO approach suggests three sources of shadow pricing:

i. Increase or decrease the total consumption in the economy
ii. Decrease or increase production in the economy
iii. Increase or decrease export or import

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Shadow pricing measurement
Sources of Shadow pricing
Increase/Decrease of consumption
Increase/Decrease of production
Increase/Decrease of export/import
Basis of shadow pricing
Consumer willingness to pay
Cost of production
Foreign exchange value

Consumer Willingness to pay:

Price

S`
D
E
P

S
D`

O
Q Quantity

DD’ = Demand Schedule

SS’ = Supply Schedule
OQ = Quantity Bought
OP = Price per unit

Total willingness = ODEQ

Price Paid = OPEQ
Consumer surplus = DEP

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Externalities

Characteristics:
‰ It is not deliberately created by the project sponsor but is an

incidental outcome of legitimate economic activity

‰ It is beyond the control of the persons who are affected by it, for

better or for worse

‰ It is not traded in the market

Examples of beneficial external effects:

‰ An oil company drilling in its own fields may generate useful

information about oil potential in the neighboring fields

‰ The approach roads built by a company may improve the

transport system in that area

‰ The training program of a firm may upgrade the skills of its

workers thereby enhancing their earning power.

Can be measured by indirect means:
‰ What the neighboring oil fields would have spent to obtain the

information
‰ The value of better transport may be estimated in terms of

increased activities and benefits derived from these.

‰ Benefit from the training program may be estimated in terms of

the increased earning power of workers

Examples of harmful external effects:

‰ A factory may cause environmental pollution and people living

adjacent to it may be exposed to health hazards

‰ Airport in a certain area may raise noise level considerably in the

neighborhood
‰ A highway may cut a farmer’s holding in two adversely affecting

his physical output.

Can be measured by indirect means:
‰ Cost of pollution in terms of loss of earnings as a result of

damage to health and cost of time spent for coping

‰ Cost of noise from difference in rent

‰ Effect of highway on consumer willingness to pay for output

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Measurement of the Impact on distribution

Groups

UNIDO approach seeks to identify income gains and losses by the followings:

• Project
• Other private business
• Government
• Workers
• Consumers
• External Sector

Measures of Gain or loss

- of individual group
- difference between the shadow price and the market price of each input or output

Savings Impact and its value

UNIDO method seeks to answer the following questions:

• Given the income distribution impact of the project what would be its effects on
savings?
• What is the value of such savings to the society?

Impact on savings
= ∑ ∆Yi MPS i

Where, ∆Yi = change in income of group i due to the project

MPSi = marginal propensity to save of group i

Income Distribution Impact

- can be determined directly by the planner

- for different income groups relative weights can be assigned
- using ‘elasticity of marginal utility of income’
n
b
wi =  
 ci 
where, wi = weight attached to income at ci level
b = base level of income that has a weight of 1
n = elasticity of the marginal utility of income

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Adjustment for Merit and Demerit Goods

Adjusting for the difference between social value and economic value:

1. Estimate the economic value

2. Calculate the adjustment factor as the difference between the ratio of social value
to economic value and unity
3. Multiply the economic value by the adjustment factor to obtain the adjustment
4. Add the adjustment to the net present value of the project