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Dev 567 Project and Program Analysis Lectures 7: Economic Appraisal of Projects (continued)

Dev 567 Project and Program Analysis Lectures 7: Economic Appraisal of Projects (continued). Dr. M. Fouzul Kabir Khan Professor of Economics and Finance North South University. Lecture 7. Shadow prices Project analysis in developing countries LMST accounting price method in practice

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Dev 567 Project and Program Analysis Lectures 7: Economic Appraisal of Projects (continued)

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  1. Dev 567Project and Program AnalysisLectures 7: Economic Appraisal of Projects (continued) Dr. M. FouzulKabir KhanProfessor of Economics and Finance North South University

  2. Lecture 7 • Shadow prices • Project analysis in developing countries • LMST accounting price method in practice • Intermediate goods and asset valuation method • Travel cost method • Social discount rate

  3. Shadow Prices • When a market does not exist or market failure leads to a divergence between market price and marginal social cost, analysts try to obtain estimates of what market price would be if the relevant good were traded in a perfect market. Such an estimate is called a shadow price • Estimates of shadow prices when markets are missing • Examples: value of a unit of time, statistical life, or the (negative) value of a particular type of crime

  4. Shadow Prices

  5. Shadow Prices

  6. Plug-Ins for Value of Travel Time Saved Shadow Prices

  7. Plug-Ins for Value of Recreational Activities (in 1999 U.S. dollars) Shadow Prices

  8. Plug-Ins for Value of Environmental Impact (in 1999 U.S. dollars) Shadow Prices

  9. Project Analysis in Developing Countries • Project Analysis in developing countries have much in common with Project Analysis in industrialized countries • The main distinguishing characteristic of Project Analysis in developing countries is the much grater emphasis on adjusting the market prices of project output and inputs so that they more accurately reflect their value to society • Markets are more distorted in developing countries • Segmented labor market • Overvalued exchange rate • Tariffs, taxes, and import controls • Formal and informal credit markets • Use shadow prices/accounting prices instead of market prices

  10. LMST Accounting Price Method • Developed by UNIDO, I.M.D Little and J.A. Mirrlees, synthesized by Lynn Squire and Herman G. van derTak • The LMST methodology • Use world prices as shadow price for all project inputs and outputs that are classified as tradable • World prices are less distorted than domestic prices • Imported input valued at import price, CIF • Exported output valued at export price, FOB • Examples • Steel plant • Agricultural crop

  11. LMST Method in Practice • Shadow pricing involves multiplying each market price by an accounting price ratio • APR for good i = accounting/shadow price of good i /market price of good i • Shadow price of good i = APR of good i *market price of good i • Small country assumption • Shadow price of an imported input or an output that is an import substitute • Shadow price of an export • Shadow price of a non-tradable good (electricity)

  12. Accounting Price of an Import • CIF price * Exchange rate = World Price in domestic currency • Use shadow exchange rate, if there is a big difference between official and market exchange rates • Accounting prices • CIF price: APR = 1 • Tariff : APR = 0 • Transport cost: APR = 0.5 • Distribution cost: APR = 0.8 • Weighted APR: 0.85 • Shadow price= Market Price*APR

  13. Accounting Price of an Imported Good

  14. Accounting Price of an Export • FOB Price • Export tax is a transfer between foreign purchaser (no standing) and the government: APR= 1 • Transport for export: APR= 0.5 • Factory gate price: APR=1 • Shadow price = 5180*1+70*0.5+1750*1 =Tk. 6965

  15. Accounting Price for Export

  16. Accounting Price of Non-tradable • LMST involves determining the equivalent value of non-tradables in world prices • Breaking down the cost of inputs into traded, non-traded and labor components • Multiply market price by applicable accounting price ratio • CIF prices: APR =1 • Domestic transfer (tariffs and taxes): APR = 0 • Labor: APR = 0.6 • Standard conversion factor: 0.80

  17. Accounting Price for Electricity Valued or Marginal Cost of Supply (in thousands of pesos)

  18. Conversion factors • Semi-input-output analysis • Consumption conversion factors Weighted average of accounting price ratios for a nationally representative market basket of goods • Standard conversion factors SCF = (M+X)/[(M+ Tm –Sm)+(X-Tx+Sx)] Where M= Total value of imports(CIF) X = Total value of exports(FOB) Tm = Total tariff on imports Tx= Total taxes on exports Sm=Total subsidies on imports Sx=Total subsidies on exports Average value of SCF for different countries 0.8 (ranges between 0.59-0.96)

  19. Shadow Pricing when Goods are in Fixed Supply • Constant marginal costs up to capacity level, up to Q1 and then completely inelastic • Whether the fixed supply is binding or not • If not binding (demand with the project within the elastic range), no change in market price. Would not affect the current consumers of electricity • Would require additional input to produce additional electricity, use shadow cost method for non-tradables • If binding, (demand with the project is in the inelastic range), market price will increase. Current consumers lose surplus and producers gain surplus • Measured in market prices, the cost of electricity would equal [(P1+P2)/2](Q1-Q2) • To convert into shadow price equivalent, multiply the cost by the consumption conversion factor( weighted average of accounting price ratios for a nationally representative market basket of goods).

  20. Shadow Pricing when Electricity is Completely Elastic and Inelastic

  21. The Shadow Price of Labor • Location of the project • Source of labor • Accounting price ratio of type j labor = Shadow price of type j labor/ the market wage for type j labor • Shadow price of foreign workers • SWf= [h + (1-h)(CCF)](PW) • Where PW is the project wage, h is the fraction of PW sent or taken home, and 1-h is the fraction spent domestically • Rural market wage • RMW = 0.5($50) + 0.25($10) + 0.25($.15) = Tk. 31.25

  22. The Social Discount Rate: Main Issues • How much current consumption society is willing to give up now in order to obtain a given increase in future Consumption? • It is generally accepted that society’s choices, including the choice of weights be based on individuals’ choices • Three unresolved issues • Whether market interest rates can be used to represent how individuals weigh future consumption relative to present consumption? • Whether to include unborn future generation in addition to individuals alive today? • Whether society attaches the same value to a unit of investment as to a unit of consumption • Different assumptions will lead to choice of different discount rate

  23. Does the Choice of Discount Rate Matter? • Generally a low discount rate favors projects with highest total benefits, irrespective of when they occur, e.g. project C • Increasing the discount rate applies smaller weights to benefits or (costs) that occur further in the future and, therefore, weakens the case for projects with benefit that are back-end loaded (such as project C), strengthens the case for projects with benefit that are front-end loaded (such as project B).

  24. NPV for Three Alternative Projects

  25. Appropriate Social Discount Rate in Perfect Markets • As individuals, we prefer to consume immediate benefits to ones occurring in the future (marginal rate of time preference) • We also face an opportunity cost of forgone interest when we spend money today rather than invest them for future use (marginal rate of return on private investment) • In a perfectly competitive market: rate of return on private investment = the market interest rates = marginal rate of time preference (MRTP) • The rate at which an individual makes marginal trade-offs is called an individuals MRTP Therefore, we may use the market interest rate as the social discount rate

  26. Equality of MRTP and Market Interest Rate

  27. Alternative Social Discount Rate in Imperfect Markets • Six potential discounting methods • Social discount rate equal to marginal rate of return on private investment, rz • Social discount rate equal to marginal rate of time preference, pz • Social discount rate equal to weighted average of pz, rzand i , where iis thegovernment’s real long-term borrowing rate • Social discount rate is the shadow price of capital • A discount rate that declines over the time horizon of the project • A discount rate SG, based on the growth in real per capita consumption

  28. Alternative Social Discount Rate in Imperfect Markets • Using the marginal rate of return on private investment • The government takes resources out of the private sector • Society must receive a higher rate of return compared to the return in the private sector • Criticism • Too high • Return on private sector investment incorporates a risk premium • Government project might be financed by taxes, displaces consumption rather than investment • Project may be financed by low cost foreign loans • Private sector return may be high because of monopoly or negative externalities • Government investment sometimes raises the private return on capital

  29. Alternative Social Discount Rate in Imperfect Markets • Using the marginal social rate of time preference, pz • Numerical values of pz • Real after-tax return on savings, around 2 percent for the US economy • Criticisms • Individuals have different MRTP • How to aggregate such individual MRTP • Market interest rate reflects MRTP of individuals currently alive • Using the weighted social opportunity cost of capital WSOC= arz + bi+ (1-a-b)pz • Numerical Value, 3 percent for the US economy

  30. Harberger’s Social Discount Rate • Social discount rate should be obtained by weighting rzand pz by the relative size of the relative contributions that investment and consumption would make toward funding the project s = arz+ (1-a)pz, where a = ΔI/(ΔI+ ΔC) and (1-a) = ΔC/(ΔI+ ΔC) • Savings are not very responsive to changes in the interest rate, ΔC is close to zero • The value of the parameter a is close to one • The marginal rate of return on private investment rz is a good approximation of true social discount rate

  31. Alternative Social Discount Rate in Imperfect Markets • Criticisms of WSOC • Criticisms applicable to use of rz and pz applies • Different discount rates for different projects based on source of financing • Use the shadow price of capital • Strong theoretical appeal • Discounting be done in four steps • Costs and benefits in each period are divided into those that directly affect consumption and those affect investment • Flows into and out of investment are multiplied by the shadow price of capital θ, to convert them into consumption equivalents • Changes in consumption are added to changes in consumption equivalents • Discounting the resultant flow by pz

  32. Alternative Social Discount Rate in Imperfect Markets • Shadow price of capital Where rzis the net return on capital after depreciation, δ is the depreciation rate of capital, f is the fraction of gross return that is reinvested, and pz is the marginal social rate of time preference • Numerical values for the θ,SPC, 1.5-2.5 for the US economy • Applying SPC in practice • Criticism of calculation and use of the SPC

  33. Alternative Social Discount Rate in Imperfect Markets • Using time-declining discount rates • Conclusion, social discounting in imperfect markets • If all costs and benefits are measured as increments to consumption, use MSRTP, pz, Boardman et. Al. suggests a value of 2 percent, sensitivity 0-4 percent • If all costs and benefits are measured as increments to private sector investment, use MRROI, rz, Boardman et. Al. suggests a value of 8 percent, sensitivity 6-10 percent • If all costs and benefits are measured as increments to both consumption and private sector investment, use SPOC, θ, toincrements in investment and then discount at MSRTP, Boardman et. Al. suggests for SPOC, a value of 1.65 percent, sensitivity 1.3-2.7 percent; and ΔI = 15 percent and, ΔC= 85 percent, in the absence of information

  34. The Social Discount Rate in Practice • Many government agencies do not discount at all • Shadow price of capital is rarely used • Governments do not use time-varying discount rates • Constant positive rate that varies from country to country • US, 7-10 percent • Canada, 10 percent, sensitivity 5-15 percent • 0-3 percent for Health and Environment Projects • ADB, EIRR of 10-12 percent

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