CHAPTER – THREE

ECONOMIC ANALYSIS OF PROJECTS

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 In financial analysis, the analyst is concerned with the
profitability of the project from an individual point of view
(firm’s profitability).
 The main objective here is to maximize the income of the firm
or to analyze the budgetary impacts.
 The financial analysis is done by applying market prices.

 In economic analysis, the objective is to maximize national

income no matter who receives it.
 But financial analysis will rarely measure a project’s
contribution to the community’s welfare.

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 Thus, the project analyst must not only be sure that a proposed
project will be profitable enough to attract investment interest
but also that the project will contribute sufficiently to the
growth of national income.
 The starting point for the economic analysis is the financial
prices.
 They are adjusted as needed to reflect the value to the society
as a whole of both the inputs and outputs of the project.

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3.1. The Rationale for Economic Analysis
 The objective of any legitimate government is promotion of
community welfare.
 They will be more concerned with their public work programs
to promote community welfare than they merely maximize
financial profits at distorted local prices.
 Prices could be distorted because of failures of markets, the
absence of perfect knowledge, and the existence of
externalities, consumer and producers surplus, government and
public goods, etc.
 As a result, it is not possible to use market prices to assess the
economic worth of projects.
 So, governments must choose projects on the basis of an
economic analysis if they wish to promote the community’s
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welfare.
 The major conditions under which it is impossible to use
market prices to assess the economic worth of projects can be
grouped under the following major headings:
1.Intervention in and failures of goods markets including the
markets for internationally traded goods.
2.Intervention in and failure of factor markets including the
market for labor, capital, and foreign exchange.
3.The existence of externalities, public goods and consumer and
producers surplus.
4.Imperfect knowledge, which the neoclassical model assumes
that consumers and producers have full knowledge about all
aspects of the economy relevant to their choice of operations.
 This is unrealistic because of poor transport and
communication and low education levels.
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Government Interventions and/or Failure of Goods Markets
A. Failure of domestic goods markets
 The true economic value of a good produced by a project,
(marginal social benefit), is in general measured by what
people are willing to pay for that good.
 Traditionally this is reflected by the market price of the
commodity.
 But the market price of that commodity will not measure what
people are willing to pay for it unless the following three
conditions are met:
1.There is no rationing of scales or price controls in the market
for the good.
 That is, QD must equal QS and the price of the good must be
its competitive demand price.
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2.There is no consumer’s surplus from the consumption of the
good.
 If people are willing to pay more than they actually have to pay
for a project output, then these market prices do not reflect the
true value of the good produced by the project.
3.There is no monopsony buyer who is large enough to force the
project to sell its output below the price that the monopsonist is
really willing to pay.
 Unless these conditions are met, the good’s market price will
not reflect people’s true willingness to pay for the good and
will not be a good measure of the welfare or utility that people
will obtain from consuming the project’s output.
 If any of these market imperfections exist, it will be necessary
to use corrective measures (shadow prices).
 Alternatively, governments may enforce compulsory deliveries
of goods and services at artificially low controlled prices.
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B. Trade protection and intervention in the markets for
internationally traded goods
 Governments frequently intervene in import markets by
imposing quotas and tariffs to protect infant industries or
activities that are internationally competitive.
 Tariffs and quotas will cause a divergence between local
market prices and the world prices of internationally traded
goods.
 The extent of this divergence may vary from industry to
industry.
 An import quota will push the domestic market cost of the
input well above the foreign exchange cost to the economy of
importing the input (world price).
 Such import quota overvalue the social cost of the traded input
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used by the project.
2. Failures of/or Intervention in Factor Markets
 The true economic cost to an economy of a project’s input, its
marginal social cost, will be measured by its economic
opportunity cost to suppliers.
 The market price of an input will equal to its opportunity cost
of production if the following conditions are met:
1.There are no rationing, price controls or taxes in factor
markets, such as fixed minimum wages, controlled interest
rates, price controls on raw materials or taxes on labor, savings
and profits, raw materials, equipment or other project inputs.
2.There is no producer’s surplus in the market price of the input
3.There are no monopsony buyers who are in a position to force
the factor’s market price below their marginal revenue product
and hence the price they would be willing to pay for it.
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A. Intervention in the market for labor
 Labor markets are frequently regulated with fixed minimum wage
rates or centrally fixed wages rates for formal sector jobs.
 If these wage rates are set above the market clearing levels, there is
likely to open unemployment or disguised unemployment.
 This is particularly true for unskilled labor.

 In the case of skilled labor, fixed wage rates may actually be set
below market clearing levels causing an artificial shortage of skilled
labor.
 In such situations, wage rate may not reflect the true social cost of
labor.
 Thus, a project analyst should adjust wage rates until they reflect the
true social cost of labour in the country, the shadow wage rate.
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B. Intervention in/or failure of capital market
 Another important factor market in which governments often
intervene by fixing prices is the capital market.
 In order to encourage investment, interest rates are often kept low.
 The interest rate paid for investible funds may be held well below
the equilibrium interest rate.
 As more people wish to borrow than to save at this low interest rate,
there will be an excess demand for capital funds.
 This will lead to ration the available credit to preferred borrowers.
 In addition government routinely tax both borrowers and lenders
introducing further distortions into the capital market.
 For these reasons, market interest rates should not be used to
discount future income streams in an economic analysis.
 The government will have to estimate the social discount rate that
better reflects the opportunity cost of using investible funds in a
project.
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C. Intervention in foreign exchange markets
 Many countries often manage their foreign exchange rate.
 Often the exchange rate is set significantly above its free
market level in terms of say a US dollar per unit of local
currency.
 Overvaluation of local currency is a common practice in
developing countries.
 Currency overvaluation creates an apparent shortage of foreign
exchange.
 This happens because at the overvalued exchange rate imports
appear cheap relative to locally produced goods unless tariffs
are imposed, demand for imports will rise.
 On the other hand currency overvaluation makes exporting as
compared with supplying the local market, financially
12 unattractive to producers.
 This will result in excess demand for foreign exchange.
 In these circumstances the official exchange rate will
understate the true value of foreign exchange to the country
concerned.
 This is given by the shadow exchange rate, SER, the amount
residents are willing to pay for the fixed quantity of foreign
exchange available.
 Use of the OER in project appraisal will have the effect of
undervaluing projects that produce exportable outputs and
overvaluing those that use imported inputs.
 The overvaluation of the exchange rate must be corrected in an
economic analysis.
 One method of doing this is to employ a shadow exchange rate
to convert foreign prices into local currency.
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3. Externalities and public Goods
 Another reason why the perfect world of neoclassical theory
fails to represent the real world is the existence of public goods
and externalities.
 A financial analysis of a project that uses or produces public
goods and externalities fails to capture the full impact of a
project on the community’s welfare.
A. The existence of externalities
 Externalities are created in the process of producing,
distributing and consuming many goods and services.
 There are positive or negative attributes or effects of a good or
service.

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 Some costs and benefits do not appear among its inputs and
outputs when it is analyzed from the enterprises or individual’s
viewpoint and thus do not enter into the financial NPV and
IRR.
 These items are considered as external to the enterprise but are
internal when they are considered from the economy’s angle.
 Somebody pays for the external costs and someone receives
these external benefits even if this is not the enterprise.

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B. The existence of public goods
 Public goods are goods and services whose use by one person
does not reduce their availability to others.
 Non-exclusion goods.

 Example:

 urban road networks

 TV and radio signals

 Disease eradication campaign

 Defense forces

 The legal system

 Public goods are usually provided free by governments and in

16 a financial analysis would therefore, be priced at zero.
 However, they do have a beneficial impact on the welfare of
those receiving them, most of whom will be willing to pay for
such goods through taxation.
 But it costs the society significant sum of money to produce
many of the public goods.
 This is a case where the market price of a good or service will
not reflect its true cost or benefit to the society.
 If the project uses public goods as inputs or produces them as
outputs it would be wrong to value them at their market price
of zero in any economic analysis of the project.
 They will have to be valued at the amount that it is estimated
people will be willing to pay for them.

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3.2. The Essential Elements of an Economic Analysis
 The economic analysis of a project has many features in
common with a financial analysis.
 These include:

1.Both involve the estimation of a project’s cost and benefits

over the life of the project for inclusion in the project’s cash
flow.
2.In both, the cash flow is discounted to determine the project’s
net present value, or other measures of project worth
3.Both may also use sensitivity or probability analysis to assess
the impact of uncertainty on the project’s NPV.

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 But an economic analysis goes beyond a financial analysis.
 That is; the essential elements of economic analysis include:
 A. The elimination (deduction) of transfer payments
within the economy from the project’s cash flow.
 Examples:
 Taxes-Personal and company income taxes, VAT, indirect
taxes, excise and stamp duties.
 Subsidies ---- Including those given via price support
schemes.
 Tariffs on imports and exports subsidies and taxes .
 Producer surplus - gains received by a supplier
 Credit transactions - loans received and repayment of
Interest and principal
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B. The estimation of economic or shadow prices for project
outputs and produced inputs (included internationally
traded and non-traded goods) to correct for any distortions
in their market prices.
 Since we use different prices, different economic and financial
NPV and IRR are obtained even if the inputs and outputs are
identical in physical terms.
C. The estimation of economic prices for non produced
project inputs (including labor, natural resources and land)
to correct for any distortions in their market prices.
D. The valuation and inclusion of any externalities created
by the project in economic analysis
E. The valuation and inclusion of any un-priced outputs or
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inputs such as public goods or social services.
3.3. Determining economic values
 Due to social, political, historical, and economic, etc reasons,
markets are distorted.
 As a result, the market prices are also distorted and do not
reflect marginal productivities and marginal utilities.
 Divergence between economic and market prices could be due
to market failure, government interventions, externalities,
public goods and distributional considerations.
 Hence serious distortions exist in the market for labor, capital,
and foreign exchange and efforts are necessary to replace the
signals from these markets by more appropriate measures.

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 The key to understanding of economic analysis is the concept
of opportunity cost.
 The opportunity cost is equal to the marginal value product
and the market price of the item in a relatively competitive
market.
 Economic pricing involves making adjustments to market
prices to correct for distortions and to retake account of
consumer and producers surplus.
 The adjusted price should then reflect the true opportunity cost
of an input or people’s willingness to pay for it.
 So, we use Shadow Price which is also called the accounting
price.
 The shadow price is what we call the economic price.
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3.3.1. Adjustment for Transfer Payments
 Transfer payments are defined as payments that are made
without receiving any good or service.
 They involve the transfer of claims over real resources from
one person or entity in society to another, rather than payments
made for the use of or received from the sale of any good or
service.
 So they do not reflect changes in the national economy.

 Some examples of items that are considered as transfer

payments are:
A. Taxes - personal and company income taxes, value added
taxes and other indirect taxes, excise taxes stamp duties, etc.
 In financial analysis a tax is clearly a cost.
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 When an individual pays taxes his net benefit is reduced.

 But this payment does not reduce national income.

 Rather it is transfer from the individual to the government so

that the income can be used for social purposes that are
important to the society.
 Thus payments of taxes does not reduce national income, it is
not a cost from the standpoint of the society as a whole.
 That is, taxes remain a part of the overall benefit stream of the
project that contributes to the increase in national income.

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B. Production Subsidies: are simply direct transfer payments
that flow in the opposite direction from taxes.
 Subsidies do not increase or decrease national income.
 It merely transfers control over resources from a taxpayer to
another individual.
 But, subsidy increases the individual’s income, so it is revenue
for the receiver.
C. Credit Transactions: Loans received and payment of interest
and capital when these transactions occur between domestic
borrower and lenders are examples of such credit transactions.
 The payment of interest and repayment of capital (debt
service) is treated as an outflow in financial analysis but
treated as transfer payments and are omitted from economic
accounts.
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D. Charitable gift or welfare support services: are also
considered as transfer payments.
E. Producer surplus- gains received by an existing supplier of a
factor as a result of an increase in the price of that factor.
 But in an economic analysis of a project, any change in
consumer surplus as a result of the project should be included
in the project’s economic cash flow, because these changes
represent real effects on peoples welfare.

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3.3.2. Efficiency or Economic shadow Prices
 In economic analysis of projects, inputs and outputs should be
valued at their contribution to the national economy, through
efficiency or shadow prices.
 The application of shadow prices is based on the underlying
notion of opportunity cost.
 From the national economic point of view, it is the alternative
production foregone or the cost of alternative supplies that
should be used to value project inputs and outputs.
 An economic or shadow price reflects the increase in welfare
resulting from one more unit of an output or input being
available.

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 Definition of shadow (accounting) prices
 Accounting or shadow prices are simply a set of prices that are
believed to better reflect the opportunity cost, i.e. the cost in
their best use, of goods and services.
 It represents all non market prices.
 It is the value used in economic analysis for a cost or a benefit
in a project when the market price is left to be a poor estimate
of economic value.
 It implies a price that has been derived from a complex
mathematical model such as linear programming.
 Efficiency shadow prices are border prices determined by
international trade.
 The project inputs and outputs are thus valued on the basis of
international trade.
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 The basic assumption here is that international market is less
distorted than the domestic market and thus taking
international price is more realistic to value the true cost of
goods and services.
 It is an estimate of efficiency prices.

 Example: shadow wage rate set by estimating the marginal

value product of labor.
 So shadow prices are used instead of domestic market prices in
guiding the allocation of resources since the market prices are
distorted and using them would lead to resource misallocation.
 In practice economic pricing involves making adjustments to
market prices to correct for distortions and to take account of
consumer and producer surplus.
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Shadow pricing and the numeraire
 The implicit objective of project analysis when project items
are valued at opportunity cost is to maximize the net resources
available to the economy.
 For many project items the opportunity cost will be given
directly by its border prices.
 A numeraire is a unit of account.

 Shadow prices can be expressed in two ways:

A. Directly in foreign exchange units - valuing all project effects

at world prices termed as the world price numeraire.
B. In domestic price units using a domestic price numeraire.

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 The use of different numeraire to express opportunity costs
will not affect the relative value of project outputs and inputs.
 Shadow price estimates can be made at two levels:

 Economic analysis

 Social analysis

 Distinction stems from the objectives pursued in project

appraisal.
 In economic analysis resource efficiency is also considered.

 In social analysis growth and income distribution objectives

are pursued.

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3.3. Traded and Non Traded Goods
 Goods and services produced by the project or that serves as project
inputs can be classified as:
 Non-traded goods

 Traded goods or

 Potentially traded goods

 Non-Traded Goods

 Non-traded goods are goods that do not enter into the international
trade because of their nature or physical characteristics.
 So the non-traded inputs and outputs of a project cannot be valued
directly at border or world prices.
 Some also consider goods which do not enter into trade because of
protection(trade barriers).
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 Example: Electricity is only rarely transmitted across frontiers.
 Unskilled labor is also another example of non-traded
commodity
 Inland transportation and cement or cement is usually
considered as non-traded goods.
 When goods do not enter into trade by their very nature
decomposing is a pre requisite to their valuation in terms of
world prices.
 For some non-traded goods no reference border prices are
available. Example: Teff.
 For other commodities the local supply price is below the CIF
price of potential imports but above the FOB price of potential
exports.

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 In both cases the non-traded inputs and outputs of the project
cannot be valued directly at border or world prices.
 So the valuation of non traded goods at world prices consists
of a number of steps.
A. Net out taxes from the domestic market price of the
commodity.
B. The net of taxes price is decomposed into its traded and non-
traded cost elements.
 For the traded components a border price is available by
definition and they are valued at this price.
 The non -traded items are further decomposed into traded and
non traded and the procedure continues until in successive
rounds the original inputs or outputs is developed into traded
components and labor.
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 Example: consider the production of electricity from coal

 Major cost elements are

 Coal, transport of coal to its site, transmission costs, wages and

salaries, etc.
 But this procedure is cumbersome if not difficult because it
requires detailed production data and cost, which are not easily
available and time consuming.
 Furthermore, the additional accuracy obtained in successive
rounds of decomposition will diminish fast.
 Thus one or two rounds of decomposition might be sufficient.

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 After one or two rounds the non-traded components will be
valued at the domestic price and multiplied by a conversion
factor, traded components will be valued at border prices and
labor at the shadow wage rate.
 If the output of a project is a non-traded good for which border
prices are however, known and if its domestic supply price is
below CIF but above the FOB, a convenient approximation is
to value it at the average of the two.

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Traded Goods
 Traded goods are defined as goods and services whose use or
production causes a change in the country’s net import or export
position.
 Traded goods produced or used by a project do not actually need to
be imported or exported themselves, but must be capable of being
imported or exported.
 Examples:
 All kinds of manufacturing
 Most agricultural goods
 Intermediate goods
 Raw materials
 Some services such as tourism and consultancy services

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 Traded goods are either exportable or importable goods (or
services).
 Exportable goods are those whose domestic cost of production
is below the FOB export price that local producers can earn
for the good on the international market.
 Importable goods are goods whose landed CIF import cost is
less than the domestic cost of producing these goods.

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 3.3.4. Measurement of the economic value of tradeables
(Valuation of Tradeables)

 In almost all cases, the economic benefits of producing

tradeable outputs and costs of using tradeable inputs are
measured by the border price of these inputs and outputs.
 An importable border price is its CIF import price - its price
landed in the importing country before the effects of any
tariffs or quantitative restrictions have been added to its price.
 The landed cost of an import on the port or other entry point in
the receiving country includes the cost of international freight
and insurance and often includes the cost of unloading onto
the port.
 But this excludes any charges after the import touches the port
and excludes all domestic tariffs and other taxes or fees.
 The CIF price represents the direct foreign exchange cost of
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the input up to the port or the border.
 The reason for using border prices to measure the economic
value of a project’s tradeables inputs can be understood in
terms of the assumption that the international markets are
comparatively competitive and free of distortions.
 The international price paid for goods and services will be a
good measure of the increase in welfare created from
consuming the foreign exchange earned by producing a
particular tradeable goods or service.
 Similarly an exportable good should be valued at a border
price or FOB export price.
 The FOB price is the price that would be earned by the
exporter after paying any costs to get the good to the border,
but before any export subsidies or taxes were imposed.

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 The border price (FOB price) should be netted from handling,
transportation and marketing expenses to arrive at the project
site price or farm/factory gate price.
 By subtracting these expenses one arrives at the factory or
farm gate value of the exportable output at border prices.
 The FOB border price is the actual foreign exchange earned
from exporting( the export price minus any marketing margins
and transport costs to get the good from the project site to the
border).


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 Import and Export substitutes
 If the project output substitutes for imports, the relevant
accounting price is the CIF of the substituted import adjusted
for marketing expenses.
 If a project uses as inputs a commodity that could otherwise
have been exported, we should value this input at the FOB
price adjusted for transportation cost, handling, marketing
margins, etc.
 For traded goods shadow prices are based on prices on the
world market, with no reference to value in domestic use or
supply.
 With suitable adjustments world prices provide a norm against
which to assess the costs of domestic production of traded
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goods.
 But finding an appropriate world price may be difficult since
export may go to different countries or imports may come from
many countries with differing imports or export prices.
 Under such circumstances one approach is to take the lowest
import price and the highest export price (optimal approach).
 Another approach may be to take an average.

 But long run prices instead of temporary prices should be used

in project appraisal.

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3.3.5. Border Parity Pricing
 World prices are normally measured as border prices
reflecting the value of a traded good at the border or port of
entry of a country.
 Border price is the unit price of a traded good at a country’s
border (FOB for exports and CIF for imports).
 However, values in project financial statements will normally
be at prices received by the project - ex - factory or farm gate
prices or paid by the project for inputs.
 To move from market to shadow price analysis, shadow prices
must be in terms of prices to the project.
 This means that for traded goods domestic margins, relating to
transport and distribution (including port handling) will have
to be added to prices at the border to obtain values at the
44
project level.
 The decomposition of these margins is referred to as border
parity pricing.
 A parity price or parity economic value is the price or value of
a project input that is based on a border price adjusted for
expenses between border and the project boundary.
 Assessing the full economic values of a traded good in a world
price system requires both its foreign exchange worth at the
border, plus the value at world price of the non-traded
activities of transportation and distribution required per unit of
output.
 Thus, for goods that are traded directly by a project, the border
parity price for the project output is the FOB price minus the
value of transport and distribution.

45
 Similarly where a project imports an input, its border parity
price is the CIF price plus transport and distribution costs.
Importable Output
 If the project’s output is an import substitute, it should be
valued at the CIF border price of the imported good for which
it is substituted.
 This represents the savings in foreign exchange and the
economic value of the project to the country.
 This CIF import price will not include any import tariffs or the
effect of quantitative restrictions such as quotas.
 The economic cost of any marketing and transport services
necessary to get the imported good from the port to the local
market should be added to this CIF value.
 In addition, the economic cost of any marketing and transport
cost incurred in getting the project’s locally produced output
should be subtracted from these economic benefits.
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Exported Output
 If a project produces goods for export, the economic benefit of
this good is world demand price, which is the FOB border
price that the project can earn for its export item.
 The FOB border price is the free on board price of the export
at the port or airport.
 This is the actual foreign exchange earned from exporting, the
export price minus any marketing margins and transport costs
to get the export item from the project to the border.

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Imported Inputs
 The full economic cost of an imported project input is the CIF
import price at the border, including the insurance and freight
costs to get the import to the project.
 These foreign exchange costs and domestic costs represent the
true cost to the economy of using the imported input.
 Any mark up on the cost of using the imported input due to
tariffs or quotas should not be included in the economic cost of
using these inputs.

48
Exportable Inputs
 Exportable inputs that are inputs into the project are valued at
their FOB price at the border.
 This is the foreign exchange that these goods could have
earned if they had not been used in the project.
 This represents their opportunity cost, and hence their true
economic costs to the economy.
 The economic cost of any marketing margin and transport
costs to get the input from its source to the border are
subtracted from this FOB price and the economic cost of any
transport and handling in getting the exportable to the project
should be added.
 Thus if an input is exportable the FOB price must be adjusted
for the difference between transport and distribution costs in
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moving the input to the project and to the port for export.
Potentially Traded Commodities
 In some cases, the distortion in the trade regime is so great that
they can actually prevent the trade of goods that would
otherwise be tradeables.
 Potentially traded goods includes all those goods and services
currently not traded by a country but would be traded if it
pursued optimum trade policies.
 These are goods that would have been tradeables in the
absence of trade restrictions.
 Many countries impose rigid import quotas, import embargos,
prohibitive import tariffs or export embargoes on at least some
imports and exports.

50
 The group of potentially traded goods falls between the traded
and non-traded goods.

Potentially Traded Input

 When the price differential between importing and local
supply is substantial, the project owner may ask the
government to import.
 Thus, if this is done, the input should be treated as traded good
and be valued at the CIF price.
 On the contrary, if the input is supplied by the local high cost
industry, it should be treated as a non-traded good.

51
Potentially Traded Outputs
 If a project output is potentially importable but not imported at
present because of high import tariffs and if the duties or
quotas are to be removed, the output should be treated as
traded.
 If such removal cannot be foreseen, then it should be treated as
a non-traded commodity.
 The same principle applies to project outputs that could be
exported if the trade barriers were removed.

52
Economic Export and Import Parity Price
Export Parity Price
CIF at point of import ( example Canada port)
Deduct-unloading at point of import
Deduct-freight to point of import
Deduct-insurance
Equals- FOB at point of export ( example A.A)
Convert foreign currency to domestic currency at official
exchange rate( L-M approach) or shadow exchange rate(
UNIDO approach)
Deduct-local port charges
Deduct- local transport and marketing( if not part of
project) at their market price and multiplied it by SCF in L-M
approach
Equals – Export Parity Price at project boundary
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 Contd---
Deduct-local storage, transport and marketing costs( if not
part of project cost) at their market price and multiplied it by
SCF in L-M approach

Equals- economic export parity price at project location( farm

gate)

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Import Parity Price
FOB price at point of export
Add-freight charges to point of import
Add-insurance charges
Add-unloading from ship to pier at port
CIF price at the harbor of importing countries
Convert foreign currency to domestic currency( multiplied by
OER) if we use L-M approach and SER if we use UNIDO
approach
Add-local port charges
Add-transport and marketing costs to relevant wholesale
market at market price and multiplied it by SCF in L-M
approach
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Equals- price at wholesale market
 Cont…

Deduct-local storage and other marketing costs at market

prices multiplied by SCF if the project produces import
substitute product but add if the project uses imported input

Equals- economic import parity price at project location

(farm/project gate price)

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Conversion Factors
 It has been already stated that all project inputs and outputs
should be valued at the world prices(border prices).
 World prices are used to measure the opportunity cost to the
economy of goods and services which can be bought and sold
on the international market.
 However, in practice, there are significant number of
commodities for which there will be no direct world price to
use as a measure of economic value.
 Example: Teff
 These commodities fall under the general heading of non-
traded goods.
 Even when non-traded goods are decomposed there always
remain items that are non traded and for which there is only
domestic market.
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 Thus, some world price equivalent figure need to be derived
for these non-traded goods.
 To estimate the accounting prices for all other non traded
goods (inputs and outputs) we use conversion factors.
 A conversion factor is defined as the factor by which we
multiply the actual price in the domestic market of an input or
output to arrive at its accounting price.
 The conversion factor is simply the ratio of the shadow price
of the item to its market price.
 A conversion factor is estimated simply by taking the ratio of
border prices (world prices) to domestic market prices of the
good.

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 Since market distortions vary from commodity to commodity,
the conversion needed varies from case to case.
 Therefore, it is possible to estimate commodity specific,
service specific, or sector specific like electricity,
transportation, construction etc., or for a basket of goods e.g.
consumption goods for a particular income group conversion
factors depending on the degree of aggregation desired.
 Thus conversion factors can be calculated at different levels:

 For individual commodities. E.g. coffee conversion factor

 For broad sector example: construction conversion factor

 For categories of expenditure. Example investment conversion

factor
 For the economy as a whole example ACF.
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 In all cases one is comparing a value at world price, which
should reflect the shadow price, with the domestic price.
 In principle we should have one conversion factor for each
non-traded commodity or for each group of commodities.
 Thus, the use of conversion factor is only the second best
approach.
 The best approach is to use the accounting price.

 Thus, for homogenous groups of goods and services it is

convenient to have readily available conversion factors to be
used in all project, instead of decomposing them every time a
project is analyzed.

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 The question now is how many conversion factors do we need?
There is no definite answer to the question.
 It all depends on the data availability, the variations of market
distortions, the time it takes to estimate conversion factors ,etc.
 In practice if data permits some five conversion factors
covering major inputs of most projects will suffice.
 But at least we need one conversion factor to multiply all the
domestic market prices of all non-traded components of the
input and output of a project.
 This parameter is called the standard conversion factor.

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The Standard Conversion Factor
 It is a summary measure to calculate accounting prices for non
traded commodities.
 In the case of Ethiopia, the standard conversion factor is interpreted
as a summary and approximate quantification of the distorted
markets (domestic) as compared to the international market.
 Therefore, it is the ratio of the value of imports and exports of a
country at border prices to their value at domestic prices.
 The formula for computing the standard conversion factor is give
as:

 Where M and X are total imports and exports respectively at world

prices converted at the official exchange rate.
 Tm and Tx are the total trade taxes on imports and exports
respectively
 Sm and Sx are total trade subsidies on imports and exports
62 respectively
 All values should refer to the same year or to an average over the
same period.
 The SCF is a summary measure to calculate accounting prices for
non traded goods.
 This is achieved by multiplying the net of taxes domestic price of
the commodity by the SCF.
 The border price is obtained by multiplying the net of taxes
domestic price of the commodity by the SCF.
 Thus, every effort must be made to decompose the non-traded goods
into traded and non traded elements and apply the SCF only to the
latter.
 The rule for the non-traded goods should be still decomposition and
the SCF should be used only when this is impossible, very difficult
or is not worth the effort.
 The SCF is revised from time to time by the central economic
authorities and adopted by planning bodies.

63
National Parameters
 There are some important parameters that have general applicability
in the sense that they are used in all projects.
 These parameters should take the same value in all projects although
they can change from time to time.
 That is; such parameters are national so that they apply to all
projects regardless of their sector, and they are economic because
they reflect the shadow price of the items concerned.
 For instance, a typical list of national economic parameters may
cover conversion factors for:
 Unskilled and skilled labor
 Some of the main non-traded sectors
 Some aggregate conversion factors such as consumption conversion
factor, a standard average conversion factor, the discount rate, etc.
64
 A project analyst can apply these parameters directly to the
project under analysis.
 They are called national parameters to distinguish them from
the project specific shadow prices.
 They are estimated by the central planners and are taken as
given by the project analyst.
 Some of the important national parameters include:

 The standard conversion factor

 The shadow wage rate

 The discount rate, and

 The shadow exchange rate( SER= Pd/Pw)

 Pd- domestic price, Pw- world price in foreign currency

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3.4. Social Cost Benefit Analysis
The Purpose of Social Cost Benefit Analysis
 In financial and economic project appraisal, it is implicitly
assumed that income distribution issues are beyond the
concern of the project analyst or that the distribution of
income in the country is considered appropriate.
 For a private commercial entrepreneur project choice is a
rather simple exercise.
 If he/she knows his/her objectives, all he/she has to do is to
ascertain which projects satisfy his/her objectives best.
 But in most countries governments are not only interested in
increasing efficiency but also in promoting greater equity.
 A financial objective is narrow one for a public agency to
pursue and for public decisions; a broader social objective
would be more appropriate.
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 When a project is chosen from alternative projects, the choice
has consequences for employment, output, consumption,
savings, foreign exchange earnings, income distribution and
other things of relevance to national objectives.
 The purpose of SCBA is to see whether these consequences
taken together are desirable in the light of the objectives of
national planning.
 Therefore, a social appraisal of projects goes beyond
economic and financial appraisal to determine which project
will increase welfare once distributional impact is considered.
 The project analysts will not be only concerned to determine
the level of project’s benefits and costs but who receives the
benefit and pays the costs.
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 In an economic analysis of a project, it is implicitly assumed
that a dollar received by any individual will increase the
community’s welfare by the same amount as a dollar
received by any other individual.
 But an extra dollar given to a very poor person will usually
increase the person’s welfare by much more than would a
dollar given to a rich person.
 A rationale in welfare economics for the social analysis of
projects is therefore, quite strong, the marginal utility of
income of a person who receives a low income is expected to
be greater than the marginal utility of income of the same
person if he/she receives a high income.

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Basic Arguments for the Application of Social Cost benefit
Analysis
 The basic arguments include:

 Existence of market imperfection

 Existence of externalities

 Concern for savings

 Concern for redistribution

 Merit wants

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 Approaches to SCBA
Two approaches for SCBA
• UNIDO Approach

• L-M Approach

UNIDO-Approach
Stage - 1
Calculation of financial profitability of the project
a) A good technical and financial analysis must be done before
a meaningful economic (social) evaluation can be made so as
to determine financial profitability.
b) Financial profitability is indicated by NPV) of the project
 UNIDO Approach Stage - 2
 Obtaining the net benefit of the project at economic (shadow)
prices
a) The commercial profitability analysis (calculated in stage 1)
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.
c) Therefore, developing shadow pries is very much vital.
UNIDO Approach - Stage 3
Adjustment for the impact of the project on Savings and
investment :
The purpose of this stage is to
• Determine the amount of income gained or lost because of the
project by different income groups (such as business,
government, workers, customers etc)
 Evaluate the net impact of these gains and losses on savings
 Measure the adjustment factor for savings and thus the
adjusted values for savings impact
 Adjust the impact on savings to the net present value
calculated in stage two.
Evaluation of the Net Impact on Savings
• Net savings Impact of the project =ΣΔYiMPSi
o Here, Δ Yi = change in income of group i as a

result of the project

o MPSi= Marginal Propensity to save of group i
Assuming that the income gained or lost by 4 group is
 Workers (W) = Rs. 250000,
 Consumer(C) = Rs. -700000,
 Project (P) = Rs 1000000,
 External (E)=Rs.500000
The Marginal Propensity to Save of these four groups is:
 MPSw=0.04,
 MPSc=0.25,
 MPSp=0.4 and
 MPSe = 0.3
Therefore, the net impact of the project on savings is:
{250000 x0.04+(-700000) x 0.25 + 100000 x 0.4 + 500000x0.3} =
Rs. 475000
Adjustment Factor for Savings (AFs)

• AFs measure the percentage by which the social value of investment

of one Re. exceeds social value of consumption of one rupee.
AFs = (MPC x MPcap) -1
CRI- (MPcap x MPS)
• Here, MPC = Marginal Propensity to Consume MPS = Marginal
Propensity to Save
• MPcap = Marginal Productivity of Capital
• CRI = Consumption Rate of Interest (Social Discount Rate)

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Assuming that MPC, MPS, MPcap and CRI of an economy is
given:
 MPC = 70%,
 MPS = 30%,
 MPcap=25% and
 CRI=10%
Therefore, adjustment factor for savings is AFs is 6.00
 Adjusted Value of the impact of the project on savings:
 Adjusted value of Savings = (Net impact on savings X AFs) =
Rs. 475000x6 = Rs. 2,850,000

 NB. This adjusted value should be added to the value of NPV

that we estimate in stage two.( if it is negative, we have to
76 deduct it).
 UNIDO Approach- Stage 4
Adjustment for the impact of the project on Income
distribution
 Govt. considers a project as an investment for the
redistribution of income in favour of economically weaker
sections or economically backward regions.
 This stage provides a value on the effects of a project on
income distribution between rich and poor and among regions
 Distribution Adjustment Factor (Weight) is calculated and the
impacts of the project on income distribution have been valued
by multiplying the adjustment factor with the particular income
of a group.
 This value will then be added to the net present value re-
calculated in stage three to produce the social net present value
of the project.
Determination of Weights
 If there are only two groups in a society, poor and rich,
the determination of weight is just an iterative process
between the analysts (at the bottom) and the planners (at
the top).
 This is called "bottom-up" approach.
 When more than two groups are involved, weights are
calculated by the elasticity of marginal utility of income.
The marginal utility of income is the weight attached to
an income is:
Wi =(b/ ci)n ( n is a power)
 where wi = weight of income at ci level
 ci = level of income of group i
 b = base level of income that has a weight of 1
 n = elasticity of the marginal utility of income
78
 Assuming that the worker group gains an income of RS
250000 from a project, the base level of income is Rs.
50000 which has a weight if 1 and elasticity of Marginal
Utility of Income is 0.20.
 Therefore, weight is 0.72

 Therefore, value of the impact of the project on income

distribution to this group is
 Rs 250000x0.72 = Rs. 180000

 Now this value will be added to the net present value

adjusted in stage three.
UNIDO Approach- Stage 5
Adjustment for Merit and Demerit Goods :
• If there is no difference between the economic value of inputs
and outputs and the social value of those, the UNIDO
approach for project evaluation ends at stage four.
• In reality, there are some goods (merit goods) in wich their
social value exceed their economic value.
• Example: oil, creation of employment etc.

• There are also some goods (demerit goods) in which their

social value is less than their economic value.
• Example: cigarette, alcohol, high -grade cosmetics etc

• Adjustment to the NPV of stage 4 is required if there is any

difference between the social and economic value
The steps of adjustment procedure are:
• Estimating the present economic value
• Calculating the adjustment factor
• Multiplying the economic value by the adjustment factor to
obtain the adjusted value
• Adding or subtracting the adjusted value to or from the NPV of
the project as calculated in stage four.
 Assume an alcohol factory is being constructed.

 The present economic value of the project is Rs. 237.78

(Adjusted NPV up to stage 4).
 The output of the project has no social value than its cost of
production.
 Cost of production is 60% of the economic price.

 Therefore, adjustment factor is: ((60/100)-1) = -0.4.

 Therefore, the adjusted value = (Rs. 237.78 x - 0.4) = Rs. -

95.11
 The NPV of the project in terms of socially acceptable
consumption is
Rs. 237.78 - 95.11) = Rs. 142.67
L-M Approach
• I.M.D. Little and James A. Mirrless have developed an approach to
SCBA which is famously known as L-M approach.
• The core of this approach is that the social cost of using a resource
in developing countries differs widely from the price paid for it
• Hence, it requires Shadow Prices to denote the real value of a
resource to society.
 This approach measures the cost and benefits in terms of
international or border prices.
 Why do they prefer Border Prices?

 It is because that the border prices represent the correct social

opportunity costs or benefits of using or producing traded goods.
Social Cost Benefit Analysis (SCBA)
• The resources of input and output of a project are classified
into:
o Labour
o Traded goods
o Non-traded goods
• Therefore, to find out the real value of these resources, the
following values are to be calculated
o Shadow wage rate (SWR)
o Shadow price of traded goods
o Shadow price of Non-traded goods
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 UNIDO VS. L-M
Similarities
 Calculation of Shadow prices to reflect social value
 Usage of Discounted Cash Flow Techniques
 Differences :
UNIDO L-M

Domestic currency is used as International price is used as

Numeraire Numeraire
Consumption is the measurement Uncommitted social income is the
base measurement base
SCBA objectives are met through At one place all SCBA objectives are
stage by stage fulfilled.
3.5. Cost Effectiveness Analysis
 Both cost - benefi t analysis (CBA) and cost - effectiveness analysis
(CEA) are useful tools for program and project evaluation.
 Cost - effectiveness analysis is a technique that relates the costs of a
program/project to its key outcomes or benefits.
 Cost - benefit analysis takes that process one step further, attempting
to compare costs with the dollar value of all (or most) of a program ’
s many benefits.
 These seemingly straightforward analyses can be applied anytime
before, after, or during a project/program implementation, and they
can greatly assist decision makers in assessing a projet ’ s efficiency.
 However, the process of conducting a CBA or CEA is much more
complicated than it may sound from a summary description.

86
 Cost - effectiveness analysis seeks to identify and place
dollars on the costs of a project.
 It then relates these costs to specific measures of project
effectiveness.
 Analysts can obtain a project ’ s cost - effectiveness (CE) ratio
by dividing costs by what we term units of effectiveness:

 Units of effectiveness are simply a measure of any quantifiable

outcome central to the project’s objectives.
87
 For example, a dropout prevention program in a high school
would likely consider the number of dropouts prevented to be
the most important outcome.
 For a policy mandating air bags in cars, the number of lives
saved would be an obvious unit of effectiveness.
 Using the formula just given and dividing costs by the
number of lives saved, you could calculate a cost -
effectiveness ratio, interpreted as “ dollars per life saved. ”
 You could then compare this CE ratio to the CE ratios of other
transportation safety policies to determine which policy costs
less per unit of outcome (in this case lives saved).
 Although it is typical to focus on one primary outcome in
CEA, an analyst could compute cost - effectiveness ratios for
88
other outcomes of interest as well.
 Mutually exclusive programmes

 Incremental cost-effectiveness ratios =

ΔC = Cost of new treatment – cost of current treatment

ΔE Effect of new treatment – effect of current treatment

89
Steps in Cost - Effectiveness and Cost - Benefi t Analysis
1. Set the framework for the analysis
2. Decide whose costs and benefits should be recognized
3. Identify and categorize costs and benefits
4. Project costs and benefits over the life of the program, if
applicable
5. Monetize (place a dollar value on) costs
6. Quantify benefits in terms of units of effectiveness (for CEA), or
monetize benefits (for CBA)
7. Discount costs and benefits to obtain present values
8. Compute a cost - effectiveness ratio (for CEA) or a net present
value (for CBA)
9. Perform sensitivity analysis
10. Make a recommendation where appropriate
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