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Subject BUSINESS ECONOMICS

Paper No and Title 16, Project Appraisal and Impact Analysis

Module No and Title 24, Little Mirrlees Analysis

Module Tag BSE_P16_M24

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS

ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Little-Mirrlees Analysis
4. Similarities in UNIDO and LM
5. Differences between UNIDO and LM
6. Classification of Inputs and Outputs of a Project
6.1. Traded goods and services
6.2. Non-traded goods and services
6.2.1. Segregation into tradable and non-tradable
6.3. Labour
7. LM’s Criterion to use World Prices
8. Shadow Prices

8.1 Shadow Prices of Traded Goods

8.2 Shadow Prices of Non-Traded Goods
8.3 Use of Conversion Factors
8.4 Shadow Wage Rate

9. Practical Problems
10. Summary

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS

ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS
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1. Learning Outcomes
After studying this module, you shall be able to -

 Know the LM Approach of Project Appraisal

 To identify the similarities between UNIDO and LM Approaches
 Learn the concept of Shadow Prices
 Tradable, labour and residual components
 Know the concept of Shadow Wage Rate

2. Introduction
The social cost benefit analysis is a methodology for evaluating projects from the social point of view. In
module 23 we have discussed one of the basic approach used for SCBA i.e. UNIDO Analysis. This
module is concerned with LM approach. An attempt has also been made to compare the similarity and
differences between the two approaches.

3. Little - Mirrlees approach

The LM Approach provides a comprehensive framework for SCBA in developing countries. In this
regard there are following two publications:

1. Manual of Industrial Project Analysis in Developing Countries, Vol. II and

2. Project Appraisal and Planning for Developing Countries

The approach has been named on the basis of their developers i.e. L. M. D. Little and J. A. Mirrlees.

4. Similarities between UNIDO and LM Approaches

The approach developed by Little and Mirrlees for social cost benefit analysis is considerably similar to
that of the UNIDO approach. The following are some of the similarities:

1. Calculation of accounting (shadow) prices for foreign exchange savings and unskilled labor.

2. Consideration of factor of equity.

3. Usage of discounted case flow analysis. It means under both the approaches, the cash flows are taken
at their present value after applying discount factor.

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS

ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS
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5. Differences between UNIDO and LM Approaches

The following are the major items of differences between both the approaches.

1. Domestic Prices vs. International Prices: L and m approach measures costs and benefits in terms of
international prices (border prices) whereas the UNIDO approach measures cost and benefits in term
of domestic rupees.

2. Social Income vs. Consumption: L and m approach measures costs and benefits in terms of
uncommitted social income whereas the UNIDO approach measures costs and benefits in terms of
consumption.

3. Stage-Wise vs. Efficiency, etc.: The L and M approach considers efficiency, savings and
redistribution together for analysis whereas in UNIDO these considerations are looked into and done
in different stages.

6. Classification of Inputs and Outputs of a Project

The inputs and outputs of a project are classified into

1. Traded goods and services

2. Non-traded goods and services

3. Labour

6.1 Traded goods and services:

The concept of Tradability of goods or services depends upon the fact whether it can be imported or
exported. If a country is unable to meet out its requirement out of domestic production and it imports
those goods, then the goods are treated as tradable. Similarly if the good can be exported instead of
domestic consumption, then also the goods are said to be tradable. But there may be trade barriers like
tariffs, quantitative restrictions, etc. due to which some goods are not traded. Tradable goods are those
goods which are actually traded. In order to be fully traded, domestic changes in demand and supply are
important. But simultaneously the impact of project should also be considered that the project is expected
to leave on market price and domestic production. The following are the relevant conditions to be fulfilled
in order to consider a good as fully traded.

1. Import Quota: If the goods are subject to an import quota, the available quantity at present is
only partially taken up or the quota will be expended to allow additional demand for inputs to be
met in the international market.

2. Perfectly Elastic Supply: The import supply tends towards perfect elasticity over the relevant
range of import volumes, which implies no rise in supply cost and thus no decrease in demand.

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS

ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS
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3. Excess Domestic Capacity: It is also important to see whether the country is able to produce
more goods in case of any requirement. For that purposes, the existence of excess capacity
should be considered. There is no excess capacity in the domestic industry, all additional supply
must come from abroad. If there is any domestic excess capacity, it must be due to shortages not
of demand, but of necessary inputs that will remain unavailable.

4. Marginal Cost Of Domestic Production: If the additional demand occurs inland, the import
price including transport costs from the port of entry do not exceed the marginal cost of local
production, so that imported good are still chapter.

5. Marginal Cost Of Purchase: The import price of the input, including taxes, is less than the
domestic marginal cost of purchase (including taxes, profit margins, etc.)

6.2 Non-Traded goods and services:

The non-tradable goods are those goods whose real domestic cost of production together with its
international transport cost is too high to permit export and too low to make import attractive. The non-
traded goods are tradable goods which are not traded because of the trade policies of the country. It
means the tradable goods that are not freely traded today will not be freely traded in future and should be
treated as non-tradable goods.

6.2.1 Segregation into tradable and non-tradable:

The inputs are segregated into trade able and non-trade able on the following lines:

i. Raw materials and stores: these are, in general, treated as traded goods.

ii. Power, fuel and water: these are treated as non-traded goods except when the cost of fuel is
significant.

iii. Repairs and maintenance: generally a non-traded item.

iv. Selling expenses: non-traded item.

v. Administrative overheads: administrative overheads contain two components: labor cost and
other expenses. The labor cost is included in the value added. Therefore, it is not considered. The
other expenses, like rent, telephone and telegraph, etc. are treated as non-traded items.

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS

ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS
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6.3 Labour:

Like other goods and services, the principles of shadow pricing are also applicable on labour.
Basically labour should be considered as a service and not goods. But for the purpose of shadow
pricing, the principles of shadow pricing used for goods are used for labour. In respect of any
project, manpower is required in addition to other inputs. It means the labour is hired for the
project. The analyst must consider the project’s impact on the rest of the economy when it hires
labour. Now there are three possible impacts on the rest of the economy, when a labour is hired,
depending upon the situation.

Situation-1 Labour taken from other employments:

It refers to situations where work is already employed and thus it is necessary to consider the
production that would be given up if they left to work in the proposed project. It means it will have
impact of taking Labour away from other users.

Situation-2 Induce the production of New Workers:

In this case the workers already working in other employment are not affected. The other projects
and industries are also not affected. This has impact of improvement of productivity of
underemployed workers, urban employment of rural workers or skilled employment of previously
unskilled, etc. It is related with use of unutilized man power available with the country.

Situation-3 Hiring from abroad:

Another way of hiring a labour may be neither to take labour from other employment nor to induce
new workers. Rather the hiring of workers is made from abroad. It definitely, has a clear-cut
economic cost.

7. LM’s Criterion to use World Prices

As a part of SCBA, in order to calculate the costs and benefits of the project, market values of inputs and
outputs are used. But these market values may not reflect their true value. That is why shadow prices are
used. Now in the process of production of goods and services, domestic as well as imported goods are
used. Similarly the benefits may also be in two prices. In order to avoid this problem professor I. M. Little
and James Mirrlees advocated the use of world prices.

8. Shadow prices

8.1 Shadow Prices of Traded Goods

Under LM approach costs and benefits are measured in terms of international prices, also referred as
border prices. The following are the provisions related with traded goods:

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS

ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS
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1. FOB Price: if a good is exported, its shadow price is its FOB price.

2. Cif Price: If a good is imported its shadow price is it CIF price.

The marginal export revenue is substituted for the FOB price if the foreign demand is not perfectly elastic
and if the foreign supply is not perfectly elastic, the border prices is that border prices represent correct
social opportunity costs or benefits of using or producing a traded good.

8.2 Shadow Prices of Non-Traded Goods

Shadow prices of non-traded goods are defined in terms of marginal social cost and benefit. The resource
used to produce an extra unit of a good is the marginal cost of a good. The value of an extra unit of the
good from social point of view is the marginal social benefit. When a good is not taxed and is consumed
by only one income group, then its marginal social benefit is equal to its market price multiplied by a
factor which represents the value assigned to an increase in the income of that group vis-vis an
consumption is 2:1, then the shadow price of thee non-traded output will be:

2/3 marginal social cost + 1/3 marginal social benefit

8.3 Use of Conversion Factors

Calculation of marginal social cost and benefit is practically difficult. Therefore, L-M suggested that the
monetary cost of a non-traded item is to be broken down into tradable, labor and residual components.
The tradable and residual components may then be converted into social cost by applying suitable social
conversion factor, the labor component’s social cost can be obtained by using shadow wage rate.

8.4 Shadow Wage Rate

This is an important, but a difficult factor in social cost benefit analysis as it is a function of several
factors:

 The marginal productivity of labor

 The cost associated with urbanization

 The cost of an additional amount committed to consumption when the consumption of workers
increases, as a result of the higher income he enjoys in urban employment.

The following is the formula for calculation of shadow wage rate which has been suggested by L-M:

SWR = c’ - (c – m)

Where SWR = shadow wage rate

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS

ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS
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C’ = additional resources devoted to consumption

1/s = value of a unit of committed resource

M = marginal product of the wage earner

The above formula can be expressed as follows to make the impact of various factors on the shadow wage
rate more clear:

SWR = m + (c’ – c) + (1 - ) (c – m)

The first term, m, represents the marginal product of labor. The shadow wage rate increase with increase
in m, (c’ – c) represents the costs of providing the consumption level of ‘c’ to the worker. In other words,
it is the additional cost to be incurred for providing the worker an urbanized life. Again higher the cost of
urbanization, (i.e. (c’ – c), higher is the shadow wage rate. 1/s is the value of each unit of committed
resource. Higher the value, lower is the shadow wage rate, if c m.

9. Practical Problems
Illustration 24.1

LM approach suggests considering Marginal Productivity of Labour, cost associated and the cost of
having an additional amount committed to consumption. While doing social cost benefit analysis using
LM approach, an economist has collected the following information:

(1) Worker’s Wage (W) = Rs. 30

(2) Output Foregone (Wi) = Rs. 9

(3) Investment Foregone (ARc) = 0.7

(4) Standardized distributional weight(di/V) = 1.5

(5) Conversion Factor (ARw ) = 0.9

(Translating wage measured in market prices into Foreign Exchange Equivalent)

Considering the SCBA approach given by LM, you are required to find out:

a) Economic Wage Rate (EWR)

b) Extra Social Cost Element

c) Social Wage Rate (SWR)

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS

ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS
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Solution:

a) Economic Wage Rate (EWR)

= (Output Foregone in Rs.) x (Conversion Factor)

= (Wi) x (ARw)

= 9 x 0.9

= Rs. 8.10

b) Extra Social Cost Element

= [(W - Wi )- (W - Wi)di/V ]

= [(30 - 9 )- (30 - 9)(1.5)]

= [(21) - (21)(1.5)]

= 21–31.5

= - 10.5

Now this value is to be multiplied by ARc. It means the evaluation is to be made at economic
price, then it gives the following:

= (- 10.50 ) x (.7)

= - 7.35

c) Social Wage Rate (SWR)

= EWR + Social Cost

= 8.10 + (- 7.35)

= 0.75

Illustration 24.2
Consider the following information in relation to a project to be analysed using social cost benefit
analysis:
(1) Worker’s Wage (W) = Rs. 60

(2) Output Foregone (Wi) = Rs. 18

(3) Investment Foregone (ARc) = 0.6

(4) Standardized distributional weight(di/V) = 1.4

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS
ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS
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(5) Conversion Factor (ARw ) = 0.7

On the basis of above information, you are required to find out:

a) Economic Wage Rate (EWR)

b) Extra Social Cost Element

c) Social Wage Rate (SWR)

Solution:

(1) Economic Wage Rate (EWR)

= (Output Foregone in Rs.) x (Conversion Factor)

= (Wi) x (ARw)

= 18 x 0.7

= Rs. 12.6

(2) Extra Social Cost Element

= [(W - Wi )- (W - Wi)di/V ] x ARc

= [(60 - 18 )–{(60 - 18)1.4}] x 0.6

= [(42) - (42)(1.4)] x 0.6

= [42–58.8 ] x 0.6

= - 16.8 x 0.6

= - 10.08

(3) Social Wage Rate (SWR)

= EWR + Social Cost

= 12.60 + (- 10.08)

= 2.52

Illustration 24.3
The following information is available:
a) Economic Wage Rate = Rs. 4

b) Social Wage Rate = Rs. 0.8

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS

ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS
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c) Conversion Factor = 0.80

Find out (1) Social Cost and (2) Output Foregone

Solution:

(1) Social Wage Rate (SWR)= EWR + Social Cost

Social Cost = Social Wage Rate – EWR

= 0.8 – 4

= - 3.2

(2) Economic Wage Rate (EWR)= (Output Foregone in Rs.) x (Conversion Factor)

Output Foregone =

Output Foregone = =Rs. 5

Example 24.4 [How to decide basis of Conversion]

While appraising a project using LM approach, the basis that can be used may be Social Conversion
factor (SCF), component-wise SCF or international prices (FOB or CIF). How the basis of conversion
is decided? In respect of following items, identify the basis of conversion:

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS

ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS
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Solution:

RULES FOR BASIS OF CONVERSION

The following are the rules for basis of conversion;

1. All non-labor inputs and outputs are valued at international prices wherein Inputs are valued at
CIF prices and Outputs are valued at FOB prices.

2. The social conversion factors (SCF) are used for tradable items where international prices are not
available and also for non-tradable items.

3. In some cases like building, transport, electricity, water, fuel, etc., the actual rupee cost is broken
down into three components tradable, labour and residual.

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS

ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS
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14. Summary
 The LM Approach has been named on the basis of their developers i.e. L. M. D. Little and J. A.
Mirrlees.
 The LM Approach is based upon two publications: Manual of Industrial Project Analysis in
Developing Countries, Vol. II and Project Appraisal and Planning for Developing Countries.
 The approach developed by Little and Mirrlees for social cost benefit analysis is considerably similar
to that of the UNIDO approach.
 LM Approach measures costs and benefits in terms of international prices (border prices)
 The LM Approach measures costs and benefits in terms of uncommitted social income
 Tradable Goods are those goods which are actually traded.
 The non-tradable goods are those goods whose real domestic cost of production together with its
international transport cost is too high to permit export and too low to make import attractive.
 For the purpose of shadow pricing, the principles of shadow pricing used for goods are used for
labour.
 Under LM approach costs and benefits are measured in terms of international prices, also referred as
border prices. FOB (Exports), CIF (for imports).

BUSINESS PAPER NO. 16 : PROJECT APPRAISAL AND IMPACT ANALYSIS

ECONOMICS MODULE NO. 24 : LITTLE MIRRLEES ANALYSIS