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Lecture Notes ECON 437/837: ECONOMIC COST -BENEFIT ANALYSIS Lecture Two

Lecture Notes ECON 437/837: ECONOMIC COST -BENEFIT ANALYSIS Lecture Two. PRINCIPLES UNDERLYING THE ECONOMIC ANALYSIS OF PROJECTS. Interface of Project with the Markets. Factor Markets → Project → Output Market (Labor & Capital)

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Lecture Notes ECON 437/837: ECONOMIC COST -BENEFIT ANALYSIS Lecture Two

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  1. Lecture Notes ECON 437/837: ECONOMIC COST-BENEFIT ANALYSIS Lecture Two

  2. PRINCIPLES UNDERLYING THE ECONOMIC ANALYSIS OF PROJECTS

  3. Interface of Project with the Markets Factor Markets → Project → Output Market (Labor & Capital) The role of microeconomics in project evaluation is to determine economic benefits or economic costs, which differ, more often than not, from financial benefits or financial Costs.

  4. Introduction to Economic Analysis • The financial analysis of a project focuses on its financial attractiveness to its private investors. • The economic analysis measures the impact of the project on the entire society. • An economic analysis of a project helps determine whether the project increases the net wealth of a country’s society as a whole or not. • A project with a negative economic net present value will serve to shrink the economy rather than grow it. For example, if $1,000 investment and NPV equals to $ -270. Then the project uses $1,000 of resources and only produces $730 of value.

  5. Estimation of Economic Prices • Financial prices are market prices, which are affected by the various tariffs, taxes, and subsidies. • Economic values may differ from financial prices because: • consumers valuation of an item may be greater than financial price they pay, e.g. road usage, water. • financial costs may not be the true costs, e.g. Natural gas is sold to electricity utility in Egypt at a financial price that is only 1/3 of international opportunity cost. • Calculating the economic values requires an understanding of how to integrate financial values, tariffs and taxes, handling and transportation costs, and exchange rate distortions.

  6. Commodity Specific Conversion Factors (CSCF) • Financial prices are market prices, which incorporate all the tariffs, taxes, and subsidies. These market distortions can often be combined and expressed as a proportional distortion D. Where the combined rate of the distortions D is expressed as a proportion of the financial price

  7. Commodity Specific Conversion Factors (CSCF) • Financial prices are market prices, which incorporate all the tariffs, taxes, and subsidies. • We use the conversion factor to convert each of the financial cashflow into the economic cost or benefit in the economic resource statement in the economic appraisal. • Suppose, the project is using (purchasing) cotton yarn, the relevant financial price to the project would be the demand price, Pd, (the price paid by the project). The financial price to the project is R22,239 and the economic value is R18,794.The economic value is less than financial price because the economic value doesn’t include tax.

  8. Table of Parameters for Financial Analysis Price of Electricity 2.20 Rs/Kwh Long term investment Production of Electricity 1,500 Gwh/year Machinery 8,000 Equipment 1,290 Gas 0.25 per Kwh Financial Cost (Given as subsidy) Land 300 of Capital 12% Coal 0.15 Rs/Kwh Cashflow: Financial Points of View (millions Rs.) Year 2001 2002 2003 2004 2005 2006 Inflows Sales 3300 3300 3300 3300 Land (Subsidy) 300 Liquidation value of investment 0 Liquidation value of land 300 Total Inflows 300 3300 3300 3300 3300 300 Outflows Land 300 Long term investment Machinery 8000 Equipment 1290 Gas 375 375 375 375 Coal 225 225 225 225 Labor Wages 120 120 120 120 Total Outflows 9,590 720 720 720 720 0 Net Cashflows -9290 2580 2580 2580 2580 300 NPV @12% -1283 Example of Financial and Economic Cashflows: the Case of Electricity Project Table of Parameters for Economic Analysis Willingness to pay for electricity 3.00 Rs/Kwh Economic Opportunity cost of Labor 80% of financial wage bill Foreign Exchange Premium 15% Subsidy on Gas 30% of Financial Cost Economic Opportunity cost of capital 10% Resource flow: Economic Points of View (millions Rs.) Year 2001 2002 2003 2004 2005 2006 CF* Inflows Sales 4500 4500 4500 4500 Land (Subsidy) 0.00 0 Liquidation value of land 1.00 300 Total Inflows 0 4500 4500 4500 4500 300 Outflows Land 1.00 300 Long term investment Machinery 1.15 9200 Equipment 1.15 1484 0.00 Gas** 1.50 560.63 560.6 560.6 560.6 Coal 1.15 258.75 258.8 258.8 258.8 Labor Wages 0.80 96 96 96 96 Total Outflows 10,984 915 915 915 915 0 Net Cashflows -10984 3585 3585 3585 3585 300 NPV @10% 566 *CF = Conversion Factors **CF for gas = [(1.3)*(1.15)]/1 = 1.5

  9. Three Postulates Underlying the Economic Evaluation Methodology • These postulates are based on a number of fundamental concepts of welfare economics. • The competitive demand price for an incremental unit of a good or service measures its economic value to the demander and hence its economic benefit. • The competitive supply price for an incremental unit of a good or service measures its economic resource cost. • Costs and benefits are added up without regard to who the gainers and losers are.

  10. Tariff /Coping Cost (US$/minute) A (MWTP) P0 = 0.280 C P1 = 0.120 Demand Q0 Q1 Data Traffic (minutes/ year) The implication of these postulates for the economic analysis of a project First Postulate • The competitive demand price (or the consumer’s willingness to pay) for each additional unit of consumption measures the economic benefit or the economic price of each incremental unit. • The demand curve reflects indifference on part of the consumer between having a particular unit of a good at that price and spending the money on other goods and services. Economic Value of Local Calls for Rural Customers Consumer Surplus (P1AC) Payment for services Economic value = Q0ACQ1 = Willingness to Pay

  11. The implication of these postulates for the economic analysis of a project (Cont’d) • Second Postulate • The competitive supply price of each incremental unit of a good measures the economic cost of the resources (inputs) that goes into the production of that unit. • Suppliers will be indifferent between selling incremental units of the good at their supply prices and using the factors to produce other goods and services. • The supply (marginal cost) curve represents the minimum prices that suppliers are willing to accept for successive units of a good or service that they supply. • In a competitive market these minimum prices represent the marginal opportunity cost of these goods. Installation (Marginal Cost) of one more terminal and demand for rural telephone calls Cost MC D2 D1 O Q0 Q1 Q2 Number of rural telephone calls

  12. The implication of these postulates for the economic analysis of a project (Cont’d) Third Postulate • Costs and benefits are added up without regard to who the gainers and losers are. • Focus on economic efficiency • Should the project be valued differently depending on whom are the beneficiaries and the losers? – Not by the economic analysis. • This methodology measures the net economic benefit of the project by subtracting the total resource costs used to produce the project’s output from the total benefits of the output. • This approach attempts to separate the social aspects of project appraisal from the economic efficiency aspects.

  13. Measuring Economic Benefits of a Project’s Output • Output from a project affects the market equilibrium. The changes in quantity demanded, quantity supplied and price translate into cost savings due to cuts in production of inefficient producers and an increase in consumption because of lowering of the market price.

  14. Value of Resources Saved Value of Increased Consumption Economic Benefits of Project Output (No Distortions) Price S0 Economic Value = WxsPs+WxdPd If no output market distortions, then: Ps = Pd = Pm A S0 + Project C P0m E G F P1m B D D0 Quantity s1 Q Q0 QT d1 Q Financial benefit is P1m (Q1d-Q1s) Economic benefit is Q1sGCQ0 + Q0CFQ1d

  15. Measuring the Economic Costs of a Project’s Inputs • A project requires inputs for production. Demand of inputs by the project deprives some consumers in the market because of an increase in the market price. The rise in the market price invites additional investment in input markets, depriving funds for other sectors. These costs together constitute project’s gross economic costs.

  16. Rand/Unit D 0+P D S 0 0 C m P A B 1 m P 0 0 d s Q Q Q 1 1 0 Units Economic Costs of Project Input (No Distortions) Value of postponed consumption Value of additional resources

  17. Small versus Large Changes in Prices • Often the quantity produced by a single project or purchased as inputs by a project, is relatively small compared to the size of the market and hence there is little or no change in the market price. • In such a situation and given that we are operating in an undistorted market, the gross financial receipts will be equal to the gross economic benefits. The triangle ABC is very small. • A difference arises only when the quantity produced by the project or demanded by the project is sufficiently large to have an impact on the prevailing market price in the sector.

  18. Weights expressed in terms of elasticities: Supply Elasticity  = Wxs = Supply Elasticity - Demand Elasticity  -  Demand Elasticity - Wxd = = Supply Elasticity - Demand Elasticity  -   Wxs = - Wxd  = (defined positively) own price elasticity of supply  = (defined negatively) own price elasticity of demand These are long-run elasticities of demand and supply. They are an average elasticity representing for the adjustments made by the market.

  19. Calculating the Economic Value of Non-Tradable Goods Economic Value = WxsPs + WxdP d • If rationing then Ws= 0 and Wd= 1 • Traded: Importable Ws = 1 and Wd = 0 Exportable Ws = 0 and Wd = 1 • Non-traded Ws 0 and Wd 0 Three classes of goods: WsWd 2/3 1/3 1/2 1/2 1/3 2/3 =weighted average of supply (Ps) and demand (Pd) price Where: Ws + Wd = 1

  20. Applying the Postulates to Determine Economic Evaluation of Non-Tradable Goods and Services in Distorted Markets • Distortions are defined as market imperfections. • The most common types of these distortions are in the form of government taxes and subsidies. Others include quantitative restrictions, price controls, and monopolies. • We need to take the type and level of distortions as given and not changed by the project when estimating the economic costs and benefits of projects. • The task of the project analyst or economist is to select the projects that increase the net wealth of country, given the current and expected regime of distortions in the country.

  21. Economic Benefits Ws P0m + Wd P0m(1+t) 1. Sales Taxes Levied on Output of Project Economic Benefit of an Output Supplied by a Project --- when a tax is imposed on sales --- Value of Resources Saved Value of Increased Consumption Financial benefit is P1m (Q1d-Q1s) Economic benefit is Q1sCBB’A’Q1d Example Wx s =1/3, Wx d=2/3 Pm=120, tx =0.15 Pe = 1/3(120) + 2/3(120)(1+0.15) = 132 Pe = 40 + 80(1.15) = 132 Pd = Pm + T if unit tax Pd = Pm(1+t) if ad valorem

  22. 2. Subsidies on Production Economic Benefits of a New Project -- when a production subsidy is present -- Value of Resources Saved Value of Increased Consumption Financial benefit is P1m (Q1d-Q1s) Economic benefit is Q1sA’B’Q0+Q0BCQ1d Or if subsidy is proportion of total cost, Example Wxs =1/3, Wxd=2/3 Pm=120, K=0.40 Pe = 1/3(120/(1-0.40)) + 2/3(120) = 146 and

  23. 3. Sales Taxes Levied on Input of Project Economic Cost of an Input Demanded by a Project --- when a tax is imposed on sales --- Value of postponed consumption Value of additional resources Financial cost is P1d (Q1s-Q1d) Economic cost is Q1dC’B’Q0 +Q0BAQ1s Example Wxs= 0.25, Wxd= 0.75, P0m = 90, t = 0.15 Pe= 0.25[90] + 0.75 [90(1+0.15)] = 100

  24. 4. Production Input Subsidized Economic Cost of an Input Demanded by a Project --- when an input subsidy is present --- Price S0 H s1 m1 P = P / (1-k) C After Subsidy 0 G S s0 m0 P = P / (1-k) B D I E d1 m1 P = P F J Value of Additional Resources d0 = m0 P P A D0+Project Value of Postponed Consumption D0 Quantity d1 0 s 1 Economic Costs Q Q Q P mx0 Wxs + Wxd P mx0 (1-k) Financial Cost is P1m (Q1d-Q1s) Economic Costis Q1dEFQ0+Q0GHQ1S Example Wxs= 0.25, Wxd= 0.75, Pm = 90, k= 0.40 Pe= 0.25[90/(1-0.4)] + 0.75(90) = 105

  25. 5. Sales Tax and Production Subsidy on Input Value of postponed consumption Value of additional resources S0 Pz B S0+subsidy C M P1d=P1m (1+tz) L P1s=P1m/(1-kz) G P0d=P0m (1+tz) N J R P0s=P0m/(1-kz) U P1m H D0 E P0m Dn+P Dn A Q1d Q1s Q0 Q2d Qz 0 Economic cost of a Project -- When a production subsidy and a sales tax are present -- Financial Cost is P1m (Q1d-Q1s) Economic Costis Q1dMGQ0 + Q0RLQ1s Example Wxs= 0.25, Wxd= 0.75 P0m = 90, t = 0.15, k = 0.4 P1s = 90/(1-0.4) = 150 , P1d = 90(1+0.15) =103 , Pe= 0.25(150) + 0.75(103) = 114

  26. Price Ps=Pm D0+P D0 Q0 Q1 Quantity Economic Value of Increase in Quantity Demanded of an Input in the Case of the Infinite Supply Elasticity - Example of Electricity Supply by Thermal Generation - • Project demand (Q1 – Q0) of a non-tradable input • Ws = 1 and Wd = 0 • If no direct subsidy then Ps = Pm

  27. 6. Environmental Externalities A Project with Pollution in the Lake Financial benefit is P1m (Q1d-Q1s) Economic benefit is Q1sA’B’BCQ1d

  28. Relationship between Market Prices and Demandand Supply Prices under Various Types of Distortions

  29. Applying the Postulates to Determine Economic Evaluation of Tradable Goods and services • The framework for the estimation of economic prices was presented for the case of non-tradable goods. • They are also applicable to the valuation of tradable goods. • These postulates are general in nature and are also applicable to tradable goods. • The methodology for the estimation of the economic prices of internationally tradable goods and services when there are distortions in their markets is also based on the three postulates. • These distortions may include customs duties on imported inputs of a project or those imported items that the project output will replace or substitute.

  30. The Economic Opportunity Cost of Capital • One of the practical ways to measure this parameter is to use the economic opportunity cost of funds that are drawn from the capital market. • In a small, open and developing economy, there are three alternative sources for these public funds: • The first source comes from those resources that would have been invested in other investment activities that have been either displaced or postponed by our project’s extraction of funds from the capital market. • The second source is from individual savers whose resources would have been spent on private consumption due to an increase in domestic savings. • The third source is additional foreign capital inflows.

  31. Foreign Exchange Externality • The foreign exchange externality is meant to capture any indirect external welfare effects that result from a project's incremental use or production of foreign exchange. • The source of this externality lies in the divergence that exists between the marginal value of a unit of foreign exchange and the marginal cost of earning that unit. • This divergence is ultimately due to import tariff, export taxes, sales taxes, excise taxes and any other tax or quantitative restrictions distortions in the markets underlying the demand and supply of foreign exchange.

  32. The Economic Opportunity Cost of Labor • In the labor market there are a variety of factors that may create a divergence between the market wage and the economic cost of a worker at the project. • This economic cost of employment reflects both the value of the market and non-market activities undertaken by the worker prior to joining the work force at the project and all other factors that govern the desirability of working at the project. • It will also take into account any tax differentials that the worker may face as a result of moving to the project from another employment or unemployment.

  33. Valuation of Non-Market Goods/Services • Revealed preference method: using the data obtained by observing the actual choices made by individuals in related markets. • State preference method: refer to direct survey approach to estimating the value placed on non-market goods or services.

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