CHAPTER SIX

ECONOMIC AND SOCIAL ANALYSIS OF PROJECT

Introduction
 Once financial price for costs and benefits have been determined and
entered in the project accounts, the analyst estimates the economic
value of a proposed project to the nation as a whole.
 The financial prices are the starting point for the economic analysis;
they are adjusted as needed to reflect the value to the society as whole
of both the inputs and outputs of the project.
 When the market price of any good or service is changed to make it
more closely represent the opportunity cost to the society, the new
value assigned becomes the “shadow price” or “accounting price” or
“economic price” or “efficiency price”.
• The shadow pricing process can be seen as a way of making
allowance to the distortions (market failure, government
intervention, externality, and linkage effects) caused by the
production or purchase of goods and services of a project.
• Were markets ideal (no market failure) with no government
intervention and externality and no linkage effect, adjustments
would not be needed. Market prices would represent the real value
of goods and services to society and would equal their shadow
prices.
 6.1. Purpose of economic analysis
A. Selection of alternatives
 The main purpose of project economic analysis is to help design and select projects
that contribute most to the welfare of a country.
 Optimal decision must be made based on the relative merit of all aspects financial,
economic, fiscal impact, environmental impact, etc.
B. Identification of winners and losers:
 A good project contributes to the country’s economic output; hence it has the
potential to make everyone better off.

 Nevertheless, normally not everyone benefits, and someone may lose.

 Moreover, groups that benefits from a project are not necessarily those that incur the
costs of the project.
 Identifying those who will gain, those who will pay and those will lose gives the
analyst insight into the incentives that various stake holders have to see that the
project is implemented as deigned.
 C. Environmental impact
 A very important difference between society’s point of view and the
private point of view concerns costs (or benefits) attributable to the
project but not reflected in its cash flows.
 The effects of the project on the environment, both negative (costs)
and positive (benefits), should be taken into account and if possible,
quantified and assigned a monetary value.
6.2. Economic and social cost-benefit analysis
A- Financial / Private CBA: In financial CBA market prices (nominal
prices) of inputs and outputs are used; the analysis is made from the
point of view of the investor; it is done for profit oriented projects; and
costs and benefits are only those which can be expressed in money
terms.
 The financial aspects of project preparation and analysis encompass
the financial effects of a proposed project on each of its various
participants: farmers, private sector firms, public corporations,
project agencies, etc...
 Our decision criterion is dependent on the private costs and benefits
of the project from the point of view of the participant.
B- Economic / National CBA: Unlike financial CBA, economic
CBA uses economic prices (accounting prices) or shadow prices;
and it is done from the point of view of the national economy.
• For this reason, it is also called analysis at efficiency prices.
• Economic analysis of projects is similar in form to financial
analysis in that both assess the profitability of an investment.
• In summary, the most important differences between
economic and financial analysis include:
 Prices: In financial analysis, market prices are normally used.
Market prices are also called financial prices or nominal prices
and or / private prices.
• In economic analysis, however, some market prices may be
changed so that they more accurately reflect economic values.
• While financial feasibility uses market prices, economic
feasibility utilizes economic prices.
• Usage of transfer payments: In economic analysis taxes and
subsidies are treated as transfer payments whereas market
prices take into account taxes and subsidies.
• In financial analysis, taxes are treated as a cost and subsidies
as a return.
• Both tariffs and subsidies represent neither costs nor benefits.
• Economic transfer is neither a benefit nor a cost to the society
but only a shift of resources within the society.
• Participants: While financial feasibility is undertaken from the
point of view of the private investor, economic feasibility is
undertaken from the point of view of the national economy.
• Hence, while the participant (s) in financial CBA is (are) the
private investor (s), the participants in the economic CBA are
all individuals within the national economy.
• Objective: While the objective of financial analysis is
maximizing private net benefit, the objective of economic
analysis is maximizing national income.
• shadow price is one that comes closer to measuring the real
value to society of a good or service than does its market
price.
• According to this concept, the use of shadow prices leads to
a higher level of national production or welfare than
reliance on market prices.
• Use of shadow prices yields higher level of national
income.
• Efficiency pricing involves pricing of goods, services, and
inputs based on their relative scarcity in the economy.
• Numeraire :- A unit of account in which the values of
inputs and outputs are to be expressed.
 6.3. Approaches of measuring economic costs &
benefits of a project
1. UNIDO Approach of Economic Analysis
 In this method economic benefits & costs may be measured at domestic
prices using consumption as the numiraire, with adjustment made for
divergence between market prices and economic values, and making
domestic and foreign resources comparable using shadow exchange rate
(SER).
 In this method, if commodities are traded, first all these traded goods will
be adjusted for any distortions in the domestic markets.
 After this adjustment is made the adjusted domestic price will be
multiplied by SER to make domestic resources be comparable with
foreign resources.
 In this method, if commodities are traded, first all these traded goods
will be adjusted for any distortions in the domestic markets.
 After this adjustment is made the adjusted domestic price will be
multiplied by SER to make domestic resources be comparable with
foreign resources.
• The easiest way for adjusting domestic market distortions
is to use border prices, c.i.f., for imports and f.o.b. for
exports and then multiply this border price expressed in
foreign currency by SER to arrive at economic border
prices.
• But, if the commodities are non-traded, i.e. if f.o.b. prices
are less than domestic prices & domestic prices less than
c.i.f. prices and if the market prices are good estimates of
opportunity cost or willingness to pay, we directly take the
market price as economic value of the item.
• But if the prices of non-traded items (goods and services
or factors of production) are distorted, we will adjust the
market price to eliminate distortions and then use these
estimates of opportunity cost as the shadow price to be
entered in the economic analysis.
SER: is the true exchange rate of currencies
OER 1 dollar in terms of birr is 16.48 (it may not true value of
dollar).
People mostly willing to pay an additional premium more than the
OER.
Ex. A Car sold in 20,000 dollar in world market, if there is no
any distortion = 329,600 birr in domestic market.
But if 50% of tax added, the value increase to 30,000 dollar
and sold for 494,400 birr in domestic market (people are
willing to pay this amount).
494,400birr/20,000 dollar = 24.72 birr for one dollar willing
to change by people.
OER of 1 dollar is not true value or do not reflect true value
because it is distort (additional 8.24 dollar willing to pay).
OER use foreign currency.
SER use domestic currency which have no need of exchange (FC to
DC).
Non-tradable Inputs and outputs
• Shadow Price = Cost of production +Consumer willingness to pay
• Shadow Pricing of Resources :
• • Assuming that for a project, one-half of the required input is collected
from additional domestic production which has a Domestic cost of birr
200000 and the rest one half is collected from diversion from other
consumers who are willing to pay birr 300000.
• Therefore the shadow price of the inputs will Be: Cost of production +
consumer willingness to pay = birr(200000+300000) = birr 500000
• Assuming that a newly establishes power station having a total capacity
of 100 million units electricity, charges tariff at birr1 for per unit
electricity consumption.
• The consumers of that particular area are willing to pay birr 1.20 for per
unit.
• Therefore, the shadow price is (birr1.20 x100 million) = birr120 million,
instead of birr100 million
Suppose we have a project producing export item that uses both
foreign & domestic inputs.
The net benefit would be estimated as:
Net benefit = SER (X-M)-D
Where
X - border price of exports in FC
M - border price of imported goods in FC
D - adjusted (economic) values of domestic goods in DC
SER - is the shadow exchange rate
Shadow Exchange Rate: Premium

The need to determine the foreign exchange premium arises because in
many countries, as a result of national trade policies (including tariffs on
imported goods & subsidies on exports), people pay a premium.
 This premium is not adequately reflected when the price of traded goods
are converted to domestic currency equivalent at the official exchange rate.
 The premium, thus, represents the additional amount that
users of traded goods, on average & throughout the economy
are willing to pay to obtain one more unit of traded goods.
 Premium is not adequately reflected when the price of traded
goods are converted to domestic currency equivalent at OER.
 Premium represent the amount on average traded goods are
miss priced in relation to non traded items when OER is used
to convert foreign exchange prices in to domestic values.
Premium is a sum of money paid in addition to a normal price.
 Domestic prices reflect the marginal willingness to pay for
consumers.
 If distortion level for all commodities is similar we could use the
ratio domestic to world price of one commodity.
 The derivation is a follows:
 Where Pd - domestic price

Pw - world price in foreign currency

 To derive an average and representative, estimates of SER that can be
applied across all traded goods, we need to take the weighted mean of
relative value of all imported & exported goods.Thus
fi the weight of the ith good
 The weights (fi) are a function of the quantities imported and

exported and of the elasticity of demand for the various imports and
the elasticity of supply for the various exports.
• Summary of UNIDO Approach
• Obtaining the net benefit of the project at economic (shadow) prices
a) The commercial profitability analysis would be sufficient only if the Project is
operated in Perfect market.
• Because, only in a perfect market, market prices can reflect the social value
b) If the market is imperfect (most of the cases in reality), net benefit of the Project is
determined by assigning shadow Prices to inputs and outputs.
• Numeraire is determined at
 Domestic currency ,rather than border price.
 Present value rather than future value, Because, "a bird in the hand is worth two
in the bush‘
• A good/service is tradable if the import (CIF) price is less or the export (FOB)
price is more than the domestic cost of production
• a) A good/service is non-tradable; if It import (CIF) price is greater than its
domestic cost of production and/or its export (FOB) price is less than its
domestic
• cost of production.
• Tradable inputs and outputs
• ● For a fully traded goods, the shadow price is border price translated into the
domestic currency at shadow foreign exchange.
 2. Little-Mirrlees Approach of Economic Analysis
 In this approach benefits and costs may be measured at world
price to reflect the true opportunity cost of outputs and inputs
using public saving measured in foreign exchange as the
numéraire (that is, converting everything into its foreign
exchange equivalent).
 The fact that foreign exchange is taken as a nureraire does not
mean that project accounts are necessarily expressed in foreign
currency.
 The unit of account can remain the domestic currency, but the
values recorded are the foreign exchange equivalent that is, how
much net foreign exchange is earned.
 But if the goods or inputs in question are non-traded goods, the analyst
needs to use conversion factor to translate domestic prices into their
border price equivalent.
 A conversation factor (CF) is the ratio of the economic (shadow) price
to the market price, that is:

 So the economic price for a non-traded good is its market price

multiplied by the conversion factor.
 How are conversion factors derived? The true cost of any good is its
marginal cost to society.
 In principle, to find the world price of non-traded goods, each good
could be decomposed into its traded and non-traded components in
successive rounds - backwards through the chain of production.
 A project that produces export goods can be assessed as follows.
 Net Present Value (NPV) = OER (X-M) - SCF.D
Where -OER- official exchange rate
X- exported goods in foreign currency
M- imported goods in foreign currency
SCF- standard conversation factor
D- price of non-traded goods in domestic currency
 To summarize, as long as SCF is the ratio of OER to SER, the two approaches - UNIDO and
Little-Mirrless - differ only to the extent that SER is different from the actual exchange rate.
Comparison of the Two Approaches
UNIDIO … NB = SER ( X- M ) – D
L-M … NB = OER (X - M) - D. SCF
 If we multiply the NB obtained in UNIDO by OER/SER, we get the result obtained in L-M
and,
 If we multiply the NB obtained in L- M by a ratio of SER/OER, we get the same result with
what we have obtained in UNIDO
• Summary the Little –Mirrlees Approach
• Assumes That A Country Can Buy And Sell Any
Quantity Of A Particular Good At A Given World
Price.
• Hence All Traded Inputs And Outputs Are Valued
At Their International Price( Cif For Importables
And Fob For Exportable)
• All Non Tradable Inputs Are Valued At Accounting
Prices
Little-Mirrlees and UNIDO dissimilarities
• UNIDO method also emphasis calculation of financial profitability of market prices along
with SCBA but this is not so done in case of Little-Mirrlces method.
• Little-Mirrlees method measures cost and benefit in terms of international currency that is
in border price or world price in $. UNIDO approach measure costs and benefits in terms
of domestic currency.
• The numeracies in case of Little-Mirrlees approach measures cost and benefit in terms of
uncommitted social income. On the other hand in UNIDO method it measures the same in
terms of domestic consumption.
• UNIDO approach focuses efficiency, saving and redistribution of income stage by stage
while Little-Mirrlees approach considers the same in totality.
 6.4.Economic export and import parity price
Export Parity Price
C.i.f. at point of import (say, Canada port)
Deduct- unloading at point of import
Deduct- freight to point of import (in this case air freight)
Deduct – insurance
Equals – f.o.b. at point of export (A.A)
Convert foreign currency to domestic currency at official exchange rate (OER) if you are using
the L-M approach or shadow exchange rate (SER) if you are using UNIDO approach
Deduct - local port charges
Deduct - local transport & marketing (if not part of project) at their economic price and
multiply it by SCF in L-M approach
Equals export parity price as project boundary
Deduct - local storage, transport & marketing costs (if not part of project cost) at their
economic price and multiply it by SCF in L-M approach

Equal economic export parity price at project location (farm gate)

 Import Parity Price
F.o.b. price at point of export
Add-freight charges to point of import
Add-insurance charges
Add- unloading from ship to pier at port
C.i.f. Price at the harbor of importing countries
Convert foreign currency to domestic one (multiply by OER) if you use L-M approach and SER
if you use UNIDO approach
Add-local port charges
Add-transport & marketing costs to relevant wholesale market at economic price and
multiply it by SCF in L-M approach
Equal price at wholesale market
Deduct-local storage & other marketing costs at economic price and SCF in L-M approach
(if not part of project cost) -this is the marketing margin between central market and the
project site. If the project uses imported inputs, we have to add this cost to the project.
Equals economic import parity price at project location (Farm/project gate price).