Chapter 5
Economic/ Social Cost-
Benefit/Analysis
Lectured By: Tesfaye
Debela
1
Contents
◦ The rational for economic analysis,
◦ Economic prices Vs financial prices,
◦ The procedures of economic analysis,
◦ The application of social/economic NPV, BCR and
IRR.
Session Objective:
◦ After the session, you will be able to identify the
terms and phrases used in economic analysis;
and appraise projects using economic analysis.
2
Economic Analysis
Is an assessment of a project’s costs and benefits
from the view point of the national economy or the
society.
Rationale for Economic Analysis is that Net private
benefits and net social benefits are different due to
the existence of:
◦ market imperfections,
◦ externalities
◦ income redistribution,
◦ Taxes and subsidies
◦ Etc.
In such circumstances, social cost analysis must
depend on shadow prices (instead of market prices)
to measure the net benefit to the society.
3
Economic Analysis
Shadow prices is the price used for analysing the cost and
benefit of a project when the market price is felt to be a
poor estimate of the economic value of a project.
Shadow price measures the value of commodity from
point of view of the society or the economy of a nation.
After estimating the shadow prices, we measure the
viability of the project through the normal process of
calculating NPV, IRR or CBR.
4
Financial Vs Economic analysis
Financial Economic
Appraise the project from the
Appraise the project from the
view point of an view point of macro or national
entrepreneurs, investor or economy or its contribution to
financier. the society.
It takes into account social
Covers only private costs and
costs and benefits.
benefits Taxes and subsidies are treated
Taxes are treated as costs as transfer payments.
and subsidies as a return. Interest on capital is never
Interest paid to external separated and deducted from
suppliers of money may be gross return because it is part
deducted to obtain the of the total return to the capital
stream of benefit available to available to the society as a
the owner of the project. whole.
The overriding objective is The objective is economic
financial viability (i.e. making viability [social benefits] based
profit) based on market price. on shadow price. 5
Therefore, market prices are often distorted
by:
Taxes
Monopolistic/Oligopolistic measures
Subsidies
Rent, Interest
Quotas
Regulatory measures
Protection, etc
And must be adjusted to reflect social value
of the project i.e., shadow price
6
In economic analysis we consider the benefits
of the project to the society such as:
Employment creation
Foreign Exchange generation or saving
Contribution to different sectors: such as
health, education, etc.
Multiplier effect (on other economic
variables in the economy)
Linkages (both forward and backward
linkages)
Economies and diseconomies of scale
Externalities, etc.
7
Conversion factor
We use conversion factor to change the
market price to shadow price.
Conversion Factor: is a number, usually less
than 1, used to multiply the domestic market
prices of goods/services and to get the
equivalent border prices so as to correct the
distortions in domestic prices of the same
goods/services.
Conversion Factor is a ratio of shadow price
(SP) to market price (MP).
SP
CF
MP SPMP * CF
8
Shadow Prices:
To obtain shadow price, we have to make
three types of adjustments to the market
prices. These are:
Economic Transfers
Traded and non-traded goods
Factors of production
Labour [skilled and unskilled]
Foreign Exchange
Domestic Capital
Land
9
Economic Transfers
Direct transfer payments are payments that
represent only the transfer of claims to real
resources from one person in the society to
another, not the use of real resources.
The most common transfer payments are
taxes, direct subsidies and credit
transactions that include (normally) loan
receipts, repayment of principal, and
interest payments.
All these entries should be taken out before
the financial accounts are adjusted to reflect
economic values.
10
How to do economic analysis?
• The starting point for economic appraisal of the project
will be a set of resources flow valued at market price of
particular year.
• Then we have to break costs and benefits in to different
components. In this we:
– Eliminate all transfer payments from the net cash flow
statements (transfer payments include taxes,
subsidies, social security, etc.)
– Distinguish foreign exchange cost and revenues from
domestic cost and revenue and then apply appropriate
shadow prices of foreign exchange to get real value.
– Distinguish between tradable goods and non-tradable
goods and then apply appropriate shadow prices for
both types of goods.
30
– Disagregate labour input in to skilled and unskilled
and apply relevant shadow wage rate to different
categories of labour inputs (b/c the shadow wage
rate for unskilled is completely different from that
of the skilled labour)
– Apply relevant shadow price for land
– Carry out the PV calculations of the adjusted
resource flows using the social rate of discount (r)
to calculate economic NPV, CBR and IRR.
– Based on the result you can make decision whether
the project is economically feasible or not
– Adjust the out come of the above calculation to take
into account externalities, which have not been
already incorporated in the shadow pricing system.
31
How to do economic analysis?
Consider the economic impact of the project on:
◦ Savings of the society - if the project contributes to saving,
increase the benefits; if not increase the cost side.
◦ Investment - if the project contributes to reinvestment,
increase the benefit side.
◦ Personal income distribution - if the project contributes to
income distribution, increase the benefit side.
◦ Regional Income distribution - if the project is generating
income to disadvantage regions, increase the benefit side.
If it is adding income to the well off to do region, increase
to the costs.
32
Afterconsidering all these
variables, financially viable
projects may turn out to be
unviable economically
33
Exercise
The following cash flow is based on market price.
Year 0 1st 2nd 3rd 4th
Annual sales unit 0 2 4 5 5
Investment -110
Working Capital 0 -10 -20 30
Sales revenue (@ birr 30/unit) 0 60 120 150 150
operating costs (@ birr 16/unit) 0 -32 -64 -80 -80
Overhead costs 0 -8 -8 -8 -8
Loan principal 0 -2 -4 -6 -8
Loan Interest 0 -0.34 -1.6 -2 -3
Tax 0 -1.2 -2 -3 -4
Annual Cash Flow Balance -110 6.46 20.4 51 77
Assume discount rate is 10%
Required: adjust the cash flow
Conversion factor to calculate shadow price based on CF and do economic
Items Conversion factor (CF) analysis and check whether the
Investment costs 0.909
Sales price 0.667
project is viable in terms of NPV,
Operating price 0.5 CBR and IRR?
Overhead cost 0.25
Working capital 0.2 1st year and 0.8 2nd year
Discount rate 0.834
34