WU Banking and Finance Program

Chapter Six: Social Cost Benefit Analysis

1. Introduction
Social cost benefit analysis (SCBA) also called economic analysis is a
methodology developed for evaluating investment project from the
point of view of the society (or economy) as a whole. SCBA is a
technique of economic analysis allowing the evaluation and determination of
economic costs and benefit, both direct and indirect, of the particular public
initiative. Used primarily for evaluating public investments (though it
can be applied to both private and public investments), economic analysis
has received increasing emphasis in recent years in view of the growing
importance of public investments in many countries, particularly in
developing countries, where governments are playing a significant role in
economic development. Economic analysis is also relevant, to a certain
extent, to private investment as these have now to be approved by various
governmental and non-governmental agencies which bring to bear larger
national consideration in their decisions.
In the context of planned economies, SCBA aids in evaluating individual
project within the planning framework which spells out national economic
objectives and broad allocation of resources to various sectors. In other
words, SCBA 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 SCBA which is a tool for analyzing and appraising individual projects.
Features of SCBA
The main features of the cost-benefit analysis are the following:
 cost-benefit analysis should be used for the evaluation and
comparison of all (i.e. not only one) realistic alternative
solutions/measures to the problem at issue;
 consequences of a public initiative – economic benefits and costs –
are assessed regardless of which public group or institution derives
them;
 it aims to estimate in monetary value all most important
constituents of the initiative’s costs and benefit (not only those having
clear market value);
 Cost-benefit assessment is based on the principles of (a)
individuals’ willingness to pay for goods or services and (b)
willingness to accept a compensation for negatives consequences
assessment takes into account the impact of the time factor on the value
of cost and benefit flows.

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2. Rationale for SCBA
In SCBA, the focus is on the social costs and benefits of the project. These
often tend to differ from the monetary costs and benefits of the project. The
principal sources of discrepancy are : Market imperfections,
Externalities, Taxes, Concern for saving, and Concern for
redistribution and Merit wants.
1 Market imperfections: Market prices, which form the basis for
computing the monetary costs and benefits from the point of view of project
sponsor reflect social values only under conditions of perfect
competition, which are rarely, if ever, realized by developing countries.
When imperfections are obtained, market prices do not reflect social
values.
The common market imperfections found in developing
counties are: rationing, Prescription of minimum wage rates, and
Foreign exchange regulation.
Rationing of a commodity means control over its price and
distribution. The price paid by a consumer under rationing is often
significantly less than the price that would prevail in a competitive market.
When minimum wage rates are prescribed, the wages paid to labor
are usually more than what the wages would be in a competitive
labor market free from such wage legislations. The official rate of
foreign exchange in most of the developing countries, which exercise
close regulation over foreign exchange, is typically less than the rate that
would prevail in the absence of foreign regulation this is why foreign
exchange usually commands premium in unofficial transactions.

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2 Externalities: A project may have beneficial external effects. For
example, it may create certain infrastructural facilities like roads which
benefit the neighboring areas. Such benefits are considered in SCBA,
though they are ignored in assessing the monetary benefits to the project
sponsors because they don’t receive any monetary compensation from those
who enjoy this external benefit created by the project. Likewise, a project
may have a harmful external effect like environmental pollution. In SCBA, the
cost of such environmental pollution is relevant, though the project sponsors
may not incur any monetary costs. It may be emphasized that externalities
are relevant in SCBA because in such analysis all costs and benefits,
irrespective to whom they accrue and whether they are paid for or not, are
relevant.
3 Taxes and Subsides: From the private point of view, taxes are definite
monetary costs and subsidies are definite monetary gains. From the
social point of view, however, taxes and subsidies are generally regarded as
transfer payments and hence considered irrelevant.
4 Concern for Savings: Unconcerned about how its benefits are
divided between consumption and savings, a private firm does not put
differential valuation on savings and consumption. From a social point of
view, however, the division of benefits between consumption and savings
(which leads to investment) is relevant, particularity in capital-scarce
developing countries. A Birr of benefits saved is deemed more valuable than
a Birr of benefits consumed. The concern of society for savings and
investment is duly reflected in SCBA wherein a higher valuation is
placed on savings and a lower valuation is put on consumption.
5 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. A Birr of benefits going to a poor section is considered more
valuable than a Birr of benefit going to an affluent (rich) section.
6 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 program or a balanced nutrition program for
school-going children even though these are not sought by consumers in the
market place. While merit wants are not relevant from the private
point of view, they are important from the social point of view.
3. UNIDO Approach
The guide by UNIDO provides a comprehensive framework for SCBA in
developing countries.

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The UNIDO method of project appraisal involves five stages:
 Calculation of financial profitability of the project measured at
market prices.
 Obtaining the net benefit of project measured in terms of
economic (efficiency) prices.
 Adjustment for the impact of the project on savings and
investments.
 Adjustments for the impact of the project on income
distributions.
 Adjustment of the impact of project on merit goods and
demerit goods whose social values differ from their economic values.
Each stage of appraisal measures the desirability of the project from a
different angle.
3.1 Financial profitability of the project measured at market prices
{The measurement of financial profitability of the project in the first stage
is similar to the financial evaluation that you thought in Financial
Management under Capital budgeting as well you do as
assignment}.
3.2 Net benefit in terms of economic (efficiency) prices
Stage two of the UNIDO approach is concerned with the determination of the
net benefit of the project in terms of economic (efficiency) prices, also
referred to as shadow prices.
Market prices represent shadow prices only under conditions of
perfect markets which are almost invariably not fulfilled in
developing countries. Hence, there is a need for developing shadow prices
and measuring net economic benefit in terms of these prices.
Shadow pricing: Basic issues
Before we deal with shadow pricing of specific resources, certain basic
concepts and issues must be discussed: choice of nume’raire,
concept of tradability, source of shadow prices, treatment of taxes,
and consumer willingness to pay.
Choice of Nume’raire: One of the important aspect of shadow pricing is
the determination of the nume’raire, the unit of account in which the
value of inputs or outputs is expressed.
To define the nume’raire, the following questions have to be answered:
 What unit of currency, domestic or foreign, should be used to express
benefits and costs?
 Should benefits and costs be measured in current values or constant
values?
 With reference to which point, present or future, should benefits and
costs be evaluated?
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 What use, consumption or investment, will be made of the income from
a project? Should the 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? To private or public?
The specification of the UNIDO nume’raire in terms of the above question 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”.
i) Concept of tradability A key issue in shadow pricing is whether a
good is tradeable or not. For a good that is tradeable, the international
price is a measure of its opportunity cost to the country. Why? For a
tradeable good, it is possible to substitute import for domestic production
and vice versa; similarly it is possible to substitute export for domestic
consumption and vice versa. Hence the international price, also referred to
as the border price, represents the ‘real’ value of the good in terms of
economic efficiency.
ii) Sources of Shadow prices The UNIDO approach suggests 4 sources
of shadow pricing, depending on the impact of the project on national
economy. A project, as it uses and produces resources, may for any given
input or output (i) increase or decrease the total consumption in the
economy, (ii) decrease or increase production in the economy, (iii)
decrease imports or increase imports, or (iv) increase exports or
decrease exports.
If the impact of the project is on consumption in the economy the basis of
shadow pricing is consumer willingness to pay. If the impact of the project is
on production in the economy, the basis of shadow pricing is the cost of
production. If the impact of project is on international trade-increase in
exports, decrease in imports, increase in imports, or decrease in exports- the
basis of shadow pricing is the foreign exchange value.
iii) Taxes When shadow prices are being calculated, taxed usually pose
difficulties. The general guidelines in the UNIDO approach with respect to
taxes are as follows: (i) 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, taxes should be included. (ii) When a project
augments domestic production by other producers, taxes should be
excluded. (iii) For fully traded goods, taxes should be ignored.
iii) Consumer Willingness to pay As noted above, if the impact of
the project is on consumption in the economy, the basis of shadow
pricing is consumer willingness to pay.
3.3 Shadow pricing of specific resources
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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 in its production results
in a corresponding increase in export or decrease in import. For fully traded
goods, the shadow price is the border price, translated in domestic
currency at the market exchange rate.
The above definition of a fully traded good implies that domestic changes in
demand or supply affect just the level of imports or exports.

For non-traded goods, the border price does not reflect its economic
values. The value of a non-traded good should be measure 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 reductions of
its consumption by others. The value of a non-traded good should be
measured in terms of its marginal cost of production if the requirement of
the project induces additional production or if the output of the project
causes reduction of production by other units.
Non-traded inputs and outputs A good is non-tradable when the
following conditions are satisfied: (i) its import price (Cost of production,
Insurance, and Freight (CIF) price) is greater than its domestic cost of
production and (ii) its export price (Freight On Board (FOB) price) is less
than its domestic cost of production.
The valuation of non-tradable is done as per the principles of shadow pricing
discussed earlier. On the 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 a marginal consumers’ willingness 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 cost of production. On the
input side, if the impact of the project is to reduce the availability of the
inputs o other users, their willingness to pay for that 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.
Externalities 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.
External effects must be taken in to account wherever it is possible to do so.
Even if these effects cannot be measured in monetary terms, some
qualitative evaluation must be attempted.
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Labor inputs The principles of shadow pricing for goods may be applied to
labor as well, though labor is considered to be service. When a project hires
labor, it could have three possible impacts on the rest the economy: it may
take labor away from other employments; it may induce the production of
new workers; and it may involve import of workers.
Capital inputs : when a capital investment is made in a project two things
happen: (i) Financial resources are converted into physical assets. (ii)
Financial resources are withdrawn from the national pool of savings and
hence alternative projects are foregone. Thus, shadow pricing of capital
investment involves two questions:
 What is the value of physical assets?
 What is the opportunity cost of capital (which reflects the benefit
foregone by sacrificing alternative project/s)?
The value (shadow prices) of physical assets is calculated the way the value
of other resource is calculated. If it is a fully traded good, its shadow price is
equal to its border price. If it is non-traded good its price is measured in
terms of cost of production (if the project induces additional domestic
production of the asset) or consumer willingness to pay (if the project takes
the asset from other users).
The opportunity cost of capital depends on how the capital required for the
project is generated. To the extent that is comes from additional savings, its
opportunity cost is measured by the consumption rate of interest (which
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. This is also called the investment rate of interest. In
practice, the consumption rate of interest may be sued as the discount rate
because in stage three of UNIDO analysis all inputs and outputs are
converted into their consumption equivalents.
Foreign exchange: The UNIDO method uses domestic currency as the
nume’raire. So the foreign exchange input of the project must be identified
and adjusted by an appropriate premium. This means that valuation of inputs
and outputs that were measured in border Birr has to be adjusted upward to
reflect the shadow price of foreign exchange.
The calculation of the shadow price of foreign exchange in terms of
consumer willingness to pay is based on the assumption that the foreign
exchange requirement of a project is met from the sacrifice of others. The
use of foreign exchange by a project, however, may also induce the
production of foreign exchange through additional exports or import
substitution. In such a case, the shadow price of foreign exchange would be

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based on the cost of producing foreign exchange, not consumer willingness
to pay for foreign exchange.
Economic Analysis (Taken from UNIDO manual)
All countries, and particularly the developing ones, face the basic economic
problem of allocating limited resources such as labor, land and other natural
resource, foreign exchange, etc. to their best use. Best use is defined as the
use where these resources make the maximum contribution in achieving
fundamental objectives specified in the development strategy of the country.
Market prices and market distortions: Under the traditional approach to
cost-benefit analysis, all inputs and outputs of a project are valued at prices
prevailing in the domestic market, with occasional adjustments for transfer
payments such as subsidies and evident taxes. The rationale of using
domestic market prices lies in the crucial, but questionable, assumption that
these prices reflect both marginal utilities of consumption and marginal
production costs. Consequently, the structure of consumption is expected to
determine optimally the structure of production and the allocation of
resources.
This assumption holds true only under the ideal conditions of perfect
competition and, therefore, the optimality of resource allocation depends on
whether such conditions actually prevail in the market. It is generally
accepted that the markets of most countries and particularly those of the
developing countries are very far from this ideal. For social, political,
historical and economic reasons, the markets of these countries are distorted
and consequently the signals they give in the form of prevailing prices are
also distorted and do not reflect marginal productivities and marginal
utilities. As a result, these prices cannot be used in allocating limited
resources optimally and this has created the need for a new set of prices to
serve this purpose.
It is believed that in many countries all sections of the domestic market are
distorted, though to varying degrees, since distortions emanating from one
section of the market have a tendency to penetrate the others. It was
recognized early that serious distortion exist in the markets for labor, capital,
and foreign exchange and efforts were made to replace the signals from
these market by more appropriate ones. To this end, the traditional cost-
benefit analysis employed what has been known as shadow wage rates,
opportunity cost of capital, and shadow foreign exchange rate respectively.
For other inputs and outputs domestic market prices were used with some
corrections for taxes and subsidies. Nevertheless, even with these
corrections and the use of shadow prices for the inputs mentioned, the
pattern of domestic consumption remained the basic determinant of
production structure and allocation of resources. In other words, the demand
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for goods and services for domestic consumption determined what should be
produced.
The current cost-benefit analysis considers international market as the main
determinant of resource allocation and productive efficiency. Even if the
degree of competitiveness of the world market is questioned, the fact
remains that trade is always possible and a country can import or export at
international prices; consequently these prices can be taken as opportunity
costs for the economy.
The new approach resorts to the international market, believed to be more
competitive, to receive signals that will guide the allocation of resources and
the structure of domestic production. Even if the degree of competitiveness
of the world market is questioned, the fact remains that trade is always
possible and a country can import or export at international prices;
consequently, these prices can be taken as opportunity costs of the
economy.
In this approach, all project inputs and outputs are valued at world prices
which are formed independent of whatever distortions prevail in the
domestic market. These world prices are accounting or shadow prices
estimated as border prices in the form of c.i.f. for imported and f.o.b. for the
exported commodities. Under this approach international trade replaces
domestic consumption structure in providing information for determining the
allocation of resources. The rationale of using international prices as the
benchmark of productive efficiency is found in the theory of comparative
advantage.
Since in this approach international efficiency, as reflected in world trade, is
the main determinant of domestic efficiency, the accounting prices of all
inputs and output should be world prices read at the borders of the country,
i.e. border prices. However, not all project inputs and outputs are traded
goods and services and world prices might not be available for those that are
non-traded. If the goods are not traded, the conversion factor can be used
(as short cuts).

Shadow prices are simply set of prices that are believed to better reflect the
opportunity cost, i.e. the cost in their best use, of different goods and
services. They are employed instead of domestic market prices in guiding
the allocation of resources since the latter are distorted and using them
would lead to resource misallocation. Often these prices are not observed
but estimated; hence the term shadow prices. Equally often, however, they
are observed, as for example in the case of world price, and therefore the
adjective “shadow” could be misleading. A more accurate term is

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“accounting prices” since these prices, estimated or observed, are used in
the calculations, in the account of he project.
With a very broad interpretation of the term accounting prices we might say
that all values relating to price and even quantities in project analysis are
shadow values. Some of these values are observed, some are estimated or
assumed and others are forecasts or even hopes. It is only when
implementation has been completed and the project is operational for some
time that the real prices and quantities will be known. Strictly speaking,
project planning is an exercise in forecasting.
Limits in the role of shadow prices
If accounting prices are considerably different from the prevailing market
prices, it is almost certain that in the implementation and operation stage we
will face input and output prices substantially different from the shadow
prices used in calculating costs and benefits at the planning stage.
Therefore, since workers and owners of other inputs don’t accept “shadow
Birrs”, it is necessary to include in project planning what is called financial
analysis, where market prices are used.
It should be clear that shadow/accounting prices do not replace market
prices in all project considerations. Their role is to guide the allocation of
resource and it ends there. Actual and not shadow capital requirements,
revenue, operating expenditures and similar matters will be determined by
prevailing market prices as will be the monetary deficit or surplus that the
project will generate. Comparing project analysis under market prices
(financial analysis) with the one under accounting prices (economic analysis),
will provide valuable information on subsidies and other government
measures that might be necessary to ensure that timely implementation and
smooth operation of the project. Although the need for possible subsidies is
revealed by financial analysis itself, it is the comparison with economic
analysis that shows the difference in returns under desirable and prevailing
market conditions and provides the justification for subsidies and other
measures.

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