Project analysis

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Chapter six
Economic Analysis
Economic (social cost benefit) analysis is a methodology for evaluating projects from the social
point of view. Economic analysis aids in evaluating individual projects within the planning
framework. In economic analysis, the focus is on social costs and benefits of a project which
tends to differ from financial analysis.
1.1. Economic Analysis Vs. Financial Analysis
Financial analysis focuses on monetary costs and benefits of the project whereas economic
analysis focuses on the social costs and benefits of the project. What are the principal sources of
discrepancies between financial analysis and economic analysis? The major sources of
discrepancies are market imperfections, externalities, taxes, concern for saving and income
redistribution, and merit and demerit goods.
1. Market imperfections
In computing the monetary costs and benefits, market prices are the base. Market prices show
social values only under conditions of perfect competition. 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 – The control of the prices and distribution of commodities. The price paid by
the consumer is less than the market price that would prevail in a competitive
market.
b) Prescription of minimum wage rates
c) Foreign exchange regulation – the official exchange rate is less than the rate that would
prevail in the absence of foreign regulations.
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

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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. Taxes and Subsidies
From financial analysis point of view, taxes are definite monetary costs and subsidies are definite
monetary gains. From the social point of view, taxes and subsidies are generally regarded as
transfer payments. Thus, taxes and subsidies are irrelevant for economic analysis.
4. 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 consumed. 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.
5. 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.
6. 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

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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.
1.2. Approaches to Economic Analysis
There are two approaches to economic analysis. These are:
A. UNIDO Approach
B. Little-Mirrlees (L–M) Approach
A. 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.
Each stage of project appraisal measures the desirability of the project from a different angle.
Except the first stage, the remaining are described in the section that follows:
Stage 2. Net Benefit in terms of Economic (Efficiency) 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

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shadow prices and hence there is a need to develop shadow prices that is used to determine net
economic benefits of the project.
Sources of shadow prices
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.
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.
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:
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 marginal consumers’ willingness to pay. On the other
hand, 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 inputs to other
users, their willingness to pay for that input represents social value. If the projects input
requirement is met by additional production of it, the production cost of it is the measure of
social value.

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3. 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 the import of foreign workers is
the wage they command.
4. 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
What is the value of 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 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).

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Stage3. Measurement of the Impact of Distribution
This is concerned with measuring the value of the project in terms of its contribution to income
redistribution among various groups. For the purpose of income distribution analysis, the society
may be divided into various groups, such as project, government, workers, consumers, external
sector, and other private business.
Within the society, the project results in a gain or loss to an individual group. The gain or loss is
computed in terms of whether the input/output is physical resources and financial transactions.
Gain or loss to an individual group on physical resources is the difference between the shadow
price and the market price of each input or output. For financial transactions, gain or loss is the
difference between the price paid and the value received.
To illustrate the computation of gain or loss, assume that Residents of certain area use 600,000
cubic meter water provided by water project. The benefit derived by the residents, measured in
terms of the willingness to pay, is equal to Br. 20 per cubic meter. The tariff paid by the residents
to the water authority is Br. 15 per cubic meter. What is the gain or loss by the residents due to
the project?
Gain = (20 – 15) x 600,000 = Br. 3,000,000
The shadow price is Br. 20 and the market price is Br. 15. Since the residents are required to pay
less than the shadow price, thus gain from the project.
Stage 4. The saving impact of the project
The scarcity of capital characterizes most of the developing countries which are concerned with
the impact of a project on savings and its value thereof. The following questions should be
answered?
- What is the impact of the project, given the income distribution impact?
- What is the value of such saving to the society?
The saving impact of the project is determined as follows:

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Saving =  ii MPSy
where:
iy = Chang in income of group i as a result of the project
MPSi = Marginal propensity to save of group i.
To illustrate the computation of saving impact of the project, assume that the income gained or
lost by three groups of the society as a result of the project is shown below:
Group 1 = Br. 600,000, Group 2 = Br. (200,000), Group 3 = Br. 400,000
The marginal propensity to save (MPS) of the three groups is as follows =
MPS1 = 0.20 MPS2 = 0.15 MPS = 0.30
What is the impact of the project on saving?
The saving impact of the project is determined as follows:
Saving = (600,000 x 0.20) + (-200,000 x 0.15) + (400,000 x 0.30)
= 120,000 – 30,000 + 120,000
= 210,000
Stage 5. Adjustment for Merit and Demerit Goods
What are merit goods? Demerit goods? A merit good is one for which the social value exceeds
the economic value. The best example of 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 dependence on foreign suppliers.
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

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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
Adjustment factor = 1
valueEconomic
valueSocial
For merit goods, the ratio of social value to economic value is greater than 1 and adjustment
factor becomes positive. On the othe120r 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
To illustrate 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:
Adjustment factor = 1
%100
%130

= 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

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B. Little-Mirrlees (L – M) Approach
I.M.D. Little and J.A Mirrlees have developed an approach to social cost benefit analysis of the
project. The UNIDO and L-M approaches have considerable similarities between them. Some of
the similarities are:
1. The calculation of shadow (Accounting) prices
2. The consideration the factor of equity
3. the use of Discounted Cash Flow (DCF) analysis
Although L-M approach and UNIDO approach are similar in some aspects, they are not without
differences.
There differences are:
UNIDO Approach L-M approach
1. Measures costs and benefits in terms of
domestic Birr
2. Measures costs and benefits in terms of
consumption
3. The analysis focuses on, efficiency,
savings, and redistribution considerations
in different stages
1. Measures costs and benefits in terms of
international (border) prices
2. Measures costs and benefits in terms of
uncommitted social income.
3. Tends to view efficiency, savings, and
redistribution considerations together.
Shadow Pricing under L-M Approach
L-M approach classified the inputs and outputs of the project into three categories. These are
a. Tradable goods and services
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.

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b. Non-tradable goods and services
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.
c. Labour
According to L-M, the shadow wage rate is the function of several factors, some of which
include:
- the marginal productivity of labour
- the cost associated with urbanization such as cost of transport, urban overheads etc.
- the cost of having an additional amount committed to consumption (when the
consumption of the worker increases as a result of the higher income he/she enjoys in
urban employment).