Economic Analysis

of Projects
Chapter 6
 Introduction
 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.
 From the standpoint of the economy as a whole,
however, 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.
Rationale/validation for Economic Analysis
 The major conditions under which it is impossible to use
market prices to assess the economic worth of projects are:
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.
 Government Interventions and/or
Failure of Goods Markets
 The true economic value of a good produced
by a project is its marginal social benefit,
 It is how much it will add to community
welfare,
 in general measured by what people are willing
to pay for that good.
 Traditionally this is reflected by the market
price of the commodity.
 Failure of domestic goods markets
 The market price of a 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.
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
it is really willing to pay.
 If any of these market imperfections exist, it will
be necessary to use corrective measures
(shadow prices).
 In many developing countries at least some prices
are set by government regulatory agencies.
 As these prices are usually set below market
clearing levels and therefore, at less than people
are willing to pay, such controlled prices
underestimate the true value of these goods to
consumers.
 For example, the existence of controlled prices that are
set below the amount that people are willing to pay for
a given quantity of output will frequently results in
 the rationing of limited supplies, either formally or via
queuing as well as corruption and black markets.
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.
 For instance, South Africa and India are thought to be
high protection countries.
 Tariffs and quotas will cause a divergence
between local market prices and the world prices
of internationally traded goods.
 The extent of this divergence will vary from
industry to industry.
Failures of or Intervention in Factor Markets
 The true economic cost to an economy of a project’s
input and 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,
2. There is no producer’s surplus /addetion 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 the price they would
be willing to pay for it.
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, therefore, will fail to
capture the full impact of a project on the community’s
welfare.
 Externalities are positive or negative attributes or effects
of a good or service, or its production, that are not
directly felt by the people who buy it and hence may not
be reflected in the price they are willing to pay for it.
 Public goods are goods and services whose use by one
person does not reduce their availability to
others…provided free by governments and in a financial
analysis would therefore, be priced at zero.
The Essential Elements of an Economic Analysis
 An economic analysis goes beyond a financial
analysis appraisal, as it will also involve all or
some of the following adjustments. In other words
the essential elements of economic analysis
include:
a) The elimination (deduction) of transfer payments
within the economy from the project’s cash flow.
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
 Determining Economic Values
 It is now generally accepted that market prices are very far
from the ideal assumption that they reflect both marginal
utilities of consumption and marginal production costs .
 But for social, political, historical and economic reasons
the markets are distorted and consequently the signals
they give (the prices) are also distorted….
 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.
 Economic pricing involves making adjustments to
market prices to correct for distortions and to
retake account of consumer and producer surplus.
 The adjusted price should then reflect the true
opportunity cost of an input or people’s willingness
to pay for it.
 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
also called the accounting price.
 The shadow price is what we call the economic
price.
 Adjustment for Transfer Payments
 Transfer payments are defined as payments that are
made without receiving any good or service.
1. Taxes - personal and company income taxes, value
added taxes and other indirect taxes, excise taxes stamp
duties, etc.
2. Production Subsidies are simply direct transfer
payments that flow in the opposite direction from taxes.
3. Credit Transactions are also transfer payments
because the lender transfers control over resources to
the borrower.
4. Charitable gift or welfare support services are also
considered as transfer payments.
5. Producer surplus - gains received by an existing
supplier of a factor as a result of an increase in the price
of that factor
 Efficiency or Economic Shadow Prices
 Once it is decided that market prices are inappropriate in
project selection, the question arises how the necessary
accounting prices should be estimated.
 Thus, the economic analysis of projects requires that
inputs and outputs be valued at their contribution to the
national economy, through efficiency or shadow prices.
 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.
 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:
1. Either they can all be expressed directly in foreign
exchange units - valuing all project effects at world prices
termed as the world price numeraire.
 If a world price numeraire is adopted, then the domestic market
price of the import substitute needs to be adjusted downward to
its world price.
2. They can be expressed in domestic price units termed
using a domestic price numeraire.
 Conversely, if a domestic price numeraire is adopted the border
price of export products need to be adjusted upwards by a certain
factor (conversion factor).
 Levels of Shadow Price
 Shadow price estimates can be made at two
levels:
1. Economic analysis
2. Social analysis
 Distinction stems from the objectives pursued in
project appraisal.
 In economic analysis resource efficiency also is
considered.
 In social analysis growth and income distribution
objectives are pursued.
 In practice estimates of the parameters needed
for a social analysis are relatively rare.
 Traded and Non Traded Goods
 Once it is agreed that market prices are
inappropriate in project selection, the question
that arises would be how the necessary
accounting prices should be estimated.
 The valuation of goods and services depends on
whether the good can be traded in international
market or whether it is consumed locally such as
in a closed economy.
 Goods and services produced by the project or
that serve as project inputs can be classified as:
1. Non-traded goods
2. Traded goods or
3. Potentially traded goods
 Non-Traded Goods
 The 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 at border or world prices directly.
 Some also consider goods which do not enter into trade because
of protection is presently instituted (trade barriers).
 Examples: Electricity, Unskilled labor, Inland transportation
 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 until the original input
or output is developed into traded components and labor.
 Traded Goods

 In almost all projects, many of the inputs will be traded

goods and a large number of projects will also have
tradable outputs.
 Traded goods are defined as goods and services whose
use or production causes a change in the country’s net
import or export position.
 They do not actually need to be imported or exported themselves,
but must be capable of being imported or exported.
 Examples: All kinds of manufacturing, Agricultural goods,
Intermediate goods, Raw materials, Some services such as
tourism and consultancy services
 In almost all cases, the economic benefits of producing
tradable outputs and costs of using tradable inputs are
measured by the border price of these inputs and outputs.
 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 tradable goods.
 Potentially traded goods included 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 tradable
goods 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.
 Conversion Factors
 It has been already stated that all project inputs and
outputs should be valued at the world prices which are the
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.
 This means that the world price reflect the terms on which it can
buy and sell on the world market.
 However, in practice there are some problems.
 It is always possible that there will be 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
trading goods, that is goods which for reasons relating to
physical characteristics, costs, or trade policy do not enter
into international trade.
 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 when the
latter cannot be observed or estimated directly.
 The more the inputs and outputs are traded, the less
will be the need to use conversion factors.
 A conversion factor is estimated simply by taking the
ratio of border prices (world prices) to domestic market
prices of the good.
 As it has been indicated earlier, the market distortions
vary from commodity to commodity, therefore, the
conversion needed varies from case to case.
 It is therefore possible to estimate commodity specific, service
specific, or sector specific
 The Standard Conversion Factor
 This is an all-inclusive conversion factor used in place of
commodity-or sector specific conversion factors, either
because they cannot be estimated accurately, or because
we believe that they cannot be estimated accurately or
because they do not differ substantially from 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.
 It is estimated as the ratio of the value of imports and
exports of a country at border prices (CIF and FOB) to
their value at domestic prices.
 The formula for computing the standard conversion factor is
give as:
M X
SCF 
( M  Tm  S m )  ( X  S x  Tx )
 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
respectively
 All values should refer to the same year or to an average over
the same period…As pointed out earlier 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.
 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.
 In other words, such parameters are national in 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.
Economic Valuation of Foreign Exchange
 In project appraisal the foreign exchange earnings and
costs are usually converted into local currency so that they
can be included in the project’s cash flow with its non
traded inputs and outputs.
 The Official Exchange Rate (OER) would be applied on
the border price of exported commodities, X (fob price)
and to that of each of the imported inputs, M (c.i.f. price) to
value of them domestically.
 This is so because we assume that the official price of
foreign exchange reflects its economic benefits to the
country concerned.
 However this is often not the case and needs to be relaxed and
see its effect on the valuation of a project’s tradable inputs and
outputs.
 The official exchange rate, OER, will be equal to the
true economic value placed on foreign exchange if
 it is able to move freely without interventions or control by the
government and
 there is no rationing of foreign exchange, no tariffs or non tariff
barriers on imports and no taxes or subsidies on exports.
 In countries where these conditions hold the market
price of foreign exchange, should be a good measure
of people’s willingness to pay for the foreign exchange
 In very few countries in the world there is little or no
government intervention and few imperfections in the
country’s traded goods and foreign exchange markets.
 In the rest, there are many distortions in the market for
foreign exchange and traded goods.
 The UNIDO Guidelines
 The UNIDO approach values all traded and non-traded
goods and services in terms of domestic price equivalent.
 Domestic prices are used as the numeraire or the
common unit if account in terms of which all project inputs
and outputs are valued.
 A project’s non-traded inputs and outputs are simply values in
domestic prices.
 The project’s traded goods inputs are firstly valued in their FOB
and CIF border prices.
 They are then converted from foreign currency to local
currency using a shadow exchange rate, SER, rather
than the official exchange rate, OER.
 This is done to better reflect the true economic value of
foreign exchange to the economy.
 The Little and Mirrlees
 Like that of UNIDO, it also values traded goods at their
border prices. However, these border prices are
converted into local currency at the Official Exchange
Rate (OER), rather than SER.
 In this approach the project’s traded inputs and outputs
are effectively kept in their border price.
 The border price (LM) approach re-values these non-
traded goods in border price equivalents using
commodity specific conversion factors.
 Multiplying the domestic price value of non-traded good
by its conversion factor has the effect of converting the
goods domestic price into its border price equivalent.
 Both non-traded and traded goods are then valued in the
same Numeraire, border price, so it is legitimate to add
them in the computation of the projects cash flow.
 The Social Discount Rate
Functions of the Social Discount Rate
 The rate at which the stream of costs and
benefits are discounted in estimating the NPV or
the rate with which the IRR is compared is the
third national parameter that should be
determined by the national bank.
 The social discount rate is the rate used to
discount a project’s economic cash flow to its
present value.
 It is a crucial parameter in cost benefit analysis.
 Like the other national parameters the discount
rate should be taken by the project analyst as
exogenously determined.
The End