Chapter14 socialcostbenefitanalysis

PROJECT APPRAISAL PLANNING AND CONTROL

1. CHAPTER 14
SOCIAL COST BENEFIT ANALYSIS

2. OUTLINE
•Rationale for SCBA
•UNIDO approach
•Net benefit in terms of economic (efficiency) prices
•Savings impact and its value
•Income distribution impact
•Adjustment for merit and demerit goods
•Little-Mirrlees approach
•Shadow prices
•SCBA by financial institutions
•Public sector investment decisions in India

3. Rationale for SCBA
InSCBAthefocusisonthesocialcostsandbenefitsoftheproject.
Theseoftentendtodifferfromthemonetarycostsandbenefitsofthe
project.Theprincipalsourcesofdiscrepancyare:
Marketimperfections
Externalities
Taxesandsubsidies
Concern for savings
Concern for redistribution
erit wants

4. UNIDO Approach
The UNIDO method of project appraisal involves five stages:
1.Calculationofthefinancialprofitabilityoftheprojectmeasuredat
marketprices.
2.Obtainingthenetbenefitoftheprojectmeasuredintermsofeconomic
(efficiency)prices.
3.Adjustmentfortheimpactoftheprojectonsavingsandinvestment
4.Adjustmentfortheimpactoftheprojectonincomedistribution
5.Adjustmentfortheimpactoftheprojectonmeritgoodsanddemerit
goodswhosesocialvaluesdifferfromtheireconomicvalues.
Eachstageofappraisalmeasuresthedesirabilityoftheprojectfroma
differentangle.

5. Net Benefits in Terms of Economic
(Efficiency) Prices
Shadow Pricing : Basic Issues
•Choice of numeraire
•Concept of tradability
•Concept of shadow prices
•Taxes
•Consumer willingness to pay
•Tradable inputs and outputs
•Non-tradable inputs and outputs
•Externalities
•Labour inputs
•Capital inputs
•Foreign exchange
Shadow Pricing of Specific Resources

6. Illustration
Presently,aferryservice,operatedprivately,isbeingusedtocrossariver.The
ferryoperatorchargesRs.3perperson.ItcostshimRs.2perperson.50,000
personsusetheferryservice.(Thismeansthatthenumberofpersonscrossing
theriverbyferryservicethroughouttheyearis50,000)
Thegovernmentisconsideringconstructionofabridgeovertheriver.Itis
estimatedthatafterthebridgeisconstructed2,50,000personswillcrossthe
riveronthebridge.ThebridgeisexpectedtocostRs3millioninitiallyandits
annualmaintenancecostwouldbeRs10,000.Ithasanindefinitelylonglife.
Oncethebridgeisconstructedtheferryoperatorisexpectedtoclosedownthe
ferryserviceandselltheferryboatsforRs.100,00.
Required:Definethesocialcostsandbenefitsofconstructingthe
bridge,assumingthatthemonetaryfiguresgiveninthe
problem represent economic values.

7. Solution:Thesocialcostsandbenefitsofbridgeconstructionmaybe
definedasfollows:
Costs
Theseconsistsofthefollowing:
1.Constructioncost:Rs.3,000,000(Thisisaone-shotcost)
2.Maintenancecost:Rs.10,000(Thisisanannualcost)
Benefits
Theseconsistofthefollowing:
1.Valueofferriesreleased:Rs100,000(Thisisone-shotbenefit)
2.Savingsinthecostofferryoperation:Rs100,000(Thisisanannual
benefit)
3.Increaseinconsumersatisfaction:Thisisequaltowillingnesstopayof
200,000additionalpersonswhoareexpectedtousethebridge.Sincethe
firstadditionalpersoniswillingtopayalmostRs3(thechargeoftheferry
operator)andthelatepersoniswillingtopayalmostnothing(thereisno
tollforusingthebridge)theaveragewillingnesstopayofadditionalusers,
assumingthatthedemandscheduleislinear,isRs.1.50.Sothewillingness
topayof200,000additionalpersonsisis200,000xRs1.50=300,000.

8. Measurement of the Impact on Distribution
StagesthreeandfouroftheUNIDOmethodareconcernedwithmeasuringthevalueof
aprojectintermsofitscontributiontosavingsandincomeredistribution.Tofacilitate
suchassessments,wemustfirstmeasuretheincomegainedorlostbyindividualgroups
withinthesociety
Forincomedistributionanalysis,thesocietymaybedividedintovariousgroups.The
UNIDOapproachseekstoidentifyincomegainsandlossesbythefollowing:
•Project
•Otherprivatebusiness
•Government
•Workers
•Consumers
• External sector
[
Thegainorlosstoanindividualgroupwithinthesocietyasaresultoftheprojectis
equaltothedifferencebetweentheshadowpriceandthemarketpriceofeachinputor
outputinthecaseofphysicalresourcesorthedifferencebetweenthepricepaidandthe
valuereceivedinthecaseoffinancialtransactions.

9. Savings Impact and its Value
Mostofthedevelopingcountriesfacescarcityofcapital.Hence,the
governmentsofthesecountriesareconcernedabouttheimpactofa
projectonsavingsanditsvaluethereof.StagethreeoftheUNIDO
method,concernedwiththis,seekstoanswerthefollowingquestions:
• Given the income distribution impact of the project
what would be its effect on savings?
• What is the value of such savings to the society?

10. Impact on Savings
The savings impact of a project is equal to:

iMPS
i
Where 
i= change in income of group i as a result of the project
MPS
i= marginal propensity to save of group i
Example As a result of a project the income gained /lost by four groups
is : Group 1 = Rs. 100,000 Group 2 = Rs 500,000, Group 3 = -
Rs.200,000 and Group 4 = -Rs 400,000. The marginal propensity to save
of these four groups is as follows:
MPS
1 = 0.05, MPS
2 = 0.10, MPS
3 = 0.20, and MPS
4 = 0.40
The impact on savings of the project is:
100,000 x 0.05 + 500,000 x 0.10 –200,000 x 0.20 –
400,000 x 0.40 = -Rs.1,45,000

11. Value of Savings
r(1-a) r(1-a)(1+ar) r(1-a)(1+ar)
n-1
(!+k) (1+k)
2
(1+k)
n
r(1-a)
(1+k) r(1-a)
(1+ar) (k-ar)
(1+k)
Where I = social value of savings (investment)
r = marginal productivity of capital
a = reinvestment rate on additional income arising
from investment
k = social discount rate
I = + +…..+ +…….
= =
1-

12. Income Distribution Impact
Manygovernmentsregardredistributionofincomeinfavourof
economicallyweakersectionsoreconomicallybackwardregionsasa
sociallydesirableobjective.Duetopracticaldifficultiesinpursuingthe
objectiveofredistributionentirelythroughthetax,subsidy,andtransfer
measuresofthegovernment,investmentprojectsarealsoconsideredas
investmentsforincomeredistributionandtheircontributiontowardthis
goalisconsideredintheirevaluation.Thiscallsforsuitablyweighing
thenetgainorlossbyeachgroup,measuredearlier,toreflecttherelative
valueofincomefordifferentgroupsandsummingthem.

13. In general, the weight attached to an income is given by the
formula:
b
n
c
i
Where w
i= weight attached to income at c
ilevel
b= base level of income that has a weight of 1
n = elasticity of the marginal utility of income
w
i

14. Adjustment for Merit and Demerit Goods
Insomecases,theanalysishastobeextendedbeyondstagefourto
reflectthedifferencebetweentheeconomicvalueandsocialvalue
ofresources.Thedifferenceexistsinthecaseofmeritgoodsand
demeritgoods.Ameritgoodisoneforwhichthesocialvalue
exceedstheeconomicvalue.Forexample,acountrymayplacea
highersocialvaluethaneconomicvalueonproductionofoilbecause
itreducesdependenceonforeignsupplies.Theconceptofmerit
goodscanbeextendedtoincludeasociallydesirableoutcomelike
creationofemployment.Intheabsenceoftheproject,the
governmentperhapswouldbewillingtopayunemployment
compensationorprovidemeremake-workjobs.
Incaseofademeritgood,thesocialvalueofthegoodislessthan
itseconomicvalue.Forexample,acountrymayregardalcoholic
productsashavingasocialvaluelessthantheeconomicvalue.

15. Little-Mirrlees Approach
ThereisconsiderablesimilaritybetweentheUNIDOapproachandtheL-Mapproach.
Boththeapproachescallfor:
1.Calculatingaccounting(shadow)pricesparticularlyforforeign
exchangesavingsandunskilledlabour.
2.Consideringthefactorofequity
3.UseofDCFanalysis
Despiteconsiderablesimilaritiestherearecertaindifferencesbetweenthetwo
approaches:
1.TheUNIDOapproachmeasurescostsandbenefitsintermsofdomestic
rupeeswhereastheL-Mapproachmeasurescostsandbenefitsintermsof
internationalprices,alsoreferredtoasborderprices.
2.TheUNIDOapproachmeasurescostsandbenefitsintermsof
consumptionwhereastheL-Mapproachmeasurescostsandbenefitsin
termsofuncommittedsocialincome.
3.Thestage-by-stageanalysisrecommendedbytheUNIDOapproachfocuses
onefficiency,savings,andredistributionconsiderationsindifferentstages.
TheL-Mapproach,however,tendstoviewtheseconsiderationstogether.

16. Shadow Prices
•Theoutputsandinputsofaprojectareclassifiedintothefollowing
categories:tradedgoodsandservices,non-tradedgoodsandservices,
andlabour.
•Theshadowpriceofatradedgoodissimplyitsborderprice
•Theshadow(oraccounting)priceofanon-tradeditemisdefinedin
termsofmarginalsocialcostandmarginalsocialbenefit.

17. Use of Conversion Factors
Ideally,theaccountingpriceofanon-tradeditemisdefinedintermsof
marginalsocialcostandmarginalsocialbenefit.Inpractice,the
calculationofmarginalsocialcostandmarginalsocialbenefitisoftena
difficulttask.Asapracticalexpedient,L-Msuggestthatthemonetary
costofanon-tradeditembebrokendownintotradable,labour,and
residualcomponents.Thetradableandresidualcomponentsmaybe
convertedintosocialcostbyapplyingsuitablesocialconversionfactors;
thelabourcomponent’ssocialcostcanbeobtainedbyusingsocialwage
rate

18. Shadow Wage Rate
Theshadowwagerateisanimportantbutdifficult-to-determineelementin
socialcostbenefitanalysis.Itisafunctionofseveralfactors:(i)the
marginalproductivityoflabour,(ii)thecostassociatedwithurbanisation
(costoftransport,urbanoverheads,etc.),and(iii)thecostofhavingan
additionalamountcommittedtoconsumptionwhentheconsumptionofthe
workerincreasesasaresultofthehigherincomeheenjoysinurban
employment.
L-M suggest the following formula for calculating the shadow wage rate:
SWR= c’–1/s(c-m)
Where SWR= shadow wage rate
c’= additional resources devoted to consumption
1/s = value of a unit of committed resource
c = consumption of the wage earner
m= marginal product of the wage earner

19. Accounting Rate of Return
Theaccountingrateofreturn(interest)istherateusedfordiscounting
socialprofits.Indeterminingtheaccountingrateofreturnthe
followingconsiderationsshouldbeborneinmind:
•The future social profit for all projects must be discounted in
the same way
•The accounting rate(s) of interest should be such that all
mutually compatible projects with positive present social value
can be undertaken.
•The accounting rate of interest should maintain some kind of
balance between investment and investible resources: too low
an accounting rate of interest would lead to over-investment
with inflationary effects and too high an accounting rate of
interest would leave savings under-utilised and result in
excessive unemployment.

20. SCBA by Financial Institutions
TheallIndiaterm-lendingfinancialinstitutions,IDBI,IFCI,andICICI(IDBI
andICICIhavenowbecomeuniversalbanks)appraiseprojectsprimarilyfrom
thefinancialpointofview.However,theyalsoscrutiniseprojectsfromthe
largersocialpointofview.ICICIwasperhapsthefirstfinancialinstitutionto
introduceasystemofeconomicanalysisasdistinctfromfinancialprofitability
analysis.IFCIadoptedasystemofeconomicappraisalin1979.Finally,IDBI
alsointroducedasystemforeconomicappraisalofprojectsfinancedbythem.
Thoughtherearesomeminorvariations,thethreeinstitutionsfollow
essentiallyasimilarapproachwhichisasimplifiedversionoftheL-M
approach.WeshalldescribetheappraisalprocedurefollowedbyIDBI.
IDBI,initseconomicappraisalofindustrialprojects,considersthreeaspects:
•Economicrateofreturn
•Effectiverateofprotection
•Domesticresourcecost

21. Economic Rate of Return
ThemethodfollowedbyIDBItocalculatetheeconomicrateofreturnmay
bedescribedasa‘PartialLittle-Mirrlees’methodbecausewhile
internationalpricesareusedforvaluationoftradableinputsandoutputs,L-
Mmethodisnotfollowedinitsentirety.ThesignificantelementsofIDBI’s
methodaredescribedbelow:
1.Internationalpricesareregardedastherelevanteconomicprices
and,hence,itisnecessarytosubstitutemarketpriceswith
internationalpricesforallnon-labourinputsandoutputs
2.Fortradableitems,whereinternationalpricesaredirectlyavailable,
CIFpricesareusedforinputsandFOBpricesareusedforoutputs
3.Fortradableitemswhereinternationalpricesarenotdirectly
availableandfornon-tradableitems(likeelectricity,transportation,
etc.),socialconversionfactorsareusedtoconvertactualrupeecost
intosocialcost.

22. Effective Rate of Protection
Tariffs, import restrictions, and subsidies are used to encourage domestic
industries and protect them against international competition. The extent to
which a project is sheltered is measured by the Effective Rate of Protection
(ERP) . It is calculated as follows:
Value added at domestic prices -Value added at world prices
Value added at world prices
This ratio is multiplied by 100 to express the ERP in percentage terms.
The data required for calculating the ERP may be arranged as follows:
At domestic prices At world prices
A. Selling price
B. Input cost: Traded
Non-traded
C. Value added

23. Domestic Resources Cost
Domesticresourcescost(DRC)reflectsthedomesticcostincurredperunitof
foreignexchangesavedorearned.Financialinstitutionsusethefollowing
formulatocalculateDRC
A+B+C
DRC= xExchangerate
P–(Q+R+S+T)
Where A= annual charge on domestic capital calculated at the rate of
10 percent.
B= annual depreciation on domestic capital assets (other than
land) calculated at the rate of 8 percent
C=annualcostofnon-tradedinputs
P=salesrealisationatinternationalprices
Q= annual charge on imported capital assets at the rate of 10
percent
R= annual depreciation on imported capital assets at the rate of 8
percent
S=annualcostofimportedinputs
T=annualcostofdomesticallyprocured,buttradableinputs

24. Public Sector Investment Decisions in India
Verybroadlytheprincipalstepsinthepublicinvestmentdecisionmakingprocess
inIndiaareasfollows:
1.ThePlanningCommissionformulatesthefive-yearplanindicatingthe
broadstrategyofplanning,theroleofeachsector,thephysicaltargetstobe
achievedbyeachsector,andthefinancialoutlaystobemadeavailablefor
thedevelopmentofeachsector.
2.Theadministrativeministriesdevelopsectoralplans.Itisintheseplansthat
theprojectsofthepublicsectorenterprisesareidentified.Theidentification
ofaprojectprovidesthegreensignalforthepreparationofitsfeasibility
report.
3.Theconcernedpublicsectorenterprisepreparesthefeasibilityreportand
forwardsittoitsadministrativeministry.
4.Theadministrativeministrycarriesoutapreliminaryscrutinyofthe
feasibilityreportandsendscopiesofthesametothevariousappraising
agencies,namely,thePlanningCommission,theDepartmentofEconomic
AffairsandthePlanFinanceDivisionoftheFinanceMinistry,andthe
BureauofPublicEnterprisesfortheircomments.

25. 5.ThePADofthePlanningCommissioncarriesoutadetailedappraisal.
Theobjectiveofitsappraisalisnotonlytosuggestwhethertoaccept
orrejecttheprojectbutalsotosuggesthowitmaybere-formulatedto
enhanceitstechnical,financial,commercial,andeconomicviability.
6.TheInvestmentPlanningCommitteeofthePlanningCommission
discussestheappraisalnoteofthePADandrecommendstothePIB
theviewofthePlanningCommissiononwhethertheprojectshouldbe
accepted,rejected,deferred,reformulated,orredesigned.
7.ThePIBconsidersthe(a)appraisalnoteofthePADalongwiththe
viewoftheplanningCommission,(b)thecommentsoftheBPE,(c)
thecommentsoftheplanfinancedivisionoftheministryoffinance,
and(d)thenoteoftheadministrativeministry.IfthePIBclearsthe
project,itsendsittothecabinetforitsapproval
8.ThecabinetgenerallyacceptstherecommendationofthePIBand
approvesitsimplementation.

26. SUMMARY
InSCBAthefocusisonsocialcostsandbenefitsofaproject.Theseoftentendto
differfromthecostsincurredinmonetarytermsandbenefitsearnedinmonetary
termsbytheproject.Theprincipalreasonsfordiscrepancyare:(i)market
imperfections,(ii)externalities,(iii)taxes,(iv)concernforsavings,(v)concernfor
redistribution,and(iv)meritanddemeritgoods
Towardstheendofthesixtiesandearlyseventiestwoprincipalapproachesfor
SCBAemerged:UNIDOapproachandLittle-Mirrleesapproach.
TheUNIDOmethodofprojectappraisalinvolvesfivestages:(i)calculationofthe
financialprofitabilityoftheprojectmeasuredatmarketprices;(ii)obtainingthenet
benefitoftheprojectmeasuredintermsofeconomic(efficiency)prices;(iii)
adjustmentfortheimpactoftheprojectonsavingsandinvestment;(iv)adjustment
fortheimpactoftheprojectonincomeredistribution;and(v)adjustmentforthe
impactoftheprojectonmeritanddemeritgoods.
AspertheL-Mapproach,theoutputsandinputsofaprojectareclassifiedintothe
followingcategories:(i)tradedgoodsandservices,(ii)non-tradedgoodsand
services,and(iii)labour.

27. Theshadowpriceofatradedgoodissimplyitsborderprice.Ifagoodisexported
itsshadowpriceisitsFOBpriceandifagoodisimporteditsshadowpriceisits
CIFprice.Theshadowpricesfornon-tradeditemsaredefinedintermsof
marginalsocialcostandmarginalsocialbenefit.
TheL-Mapproachsuggeststhefollowingformulaforcalculatingtheshadow
wagerate(SWR)SWR=c’–1/s(c-m)
Whiletheall-Indiaterm-lendinginstitutions–IDBI,IFCI,andICICI-approach
projectproposalsprimarilyfromthefinancialpointofview,theyalsoevaluate
themfromthelargersocialpointofview.
Thoughtherearesomeminorvariations,thethreeinstitutionsfollowessentiallya
similarapproachwhichisasimplifiedversionoftheL-Mapproach.
IDBI,theapexterm-lendingfinancialinstitutions,considersthreeaspectsinits
economicappraisalofindustrialprojects:economicrateofreturn,effectiverate
ofprotection,anddomesticresourcecost
Theeconomicrateofreturnissimplytheinternalrateofreturnofthestreamof
socialcostsandbenefits.
Theeffectiverateofprotectioniscalculatedasfollows:Valueaddedatdomestic
prices-ValueaddedatworldpricesValueaddedatworldprices.

28. Tillthemiddleofthesixtiesthemechanismforappraisalandselectionofpublic
sectorprojectswasratherprimitive.Toimprovethequalityofprojectplanning
andstrengthenthepublicinvestmentdecisionmakingprocessseveralstepswere
taken:creationoftheBureauofPublicEnterprises;establishmentoftheProject
AppraisalDivision(PAD)inthePlanningCommission;andinstitutionofthe
PublicInvestmentBoard(PIB).