Development planning and

project Analysis
PART II

By: Shuramu T.
 CHAPTER THREE

ECONOMIC ANALYSIS OF PROJECTS

3.1. An overview of economic analysis
Major Questions That Economic Analysis Should Answer
1. What Is the Objective of the Project?
The first step in the economic analysis of a project is to
define clearly its objective(s).
A clear definition is essential for reducing the number
of alternatives to consider and for selecting the tools
of analysis and the performance indicators.
2. What Will Happen if the Project Proceeds or Not?
One of the most fundamental questions concerns a
counterfactual:
What would the world look like without the project?
What would it look like with the project?
What will be the impact of the project on various
groups in society?
 In particular, what will be the impact of the project on the
provision of goods and services in the private sector?
 Cont’d
3. Is the Project the Best Alternative?
 Alternatives could involve, for example,
 different technical specifications,
 policy or institutional reforms, or
 location, beneficiaries, financial arrangements, or
 differences in the scale or timing of the project.
 How would the costs and benefits of alternatives compare with
those of the project?
 Comparison of alternatives helps planners choose the best way to
accomplish their objectives.
4. the Project Have Separable Components?
5. Is the Project Financially Sustainable
6. What Is the Project's Environmental Impact?
7. Techniques for Assessment: Is the Project Worthwhile?
8. Is This a Risky Project?
a) With and Without Comparisons
 Whatever the nature of the project, its implementation reduces the
supply of inputs and increases the supply of outputs available to the rest
of the economy.
 By examining the difference between the availability of inputs and outputs
with and without the project, the analyst identifies incremental costs and
benefits.
 This is not normally the same as a before and after the project
comparison.
 The with and without comparison attempts to measure the
incremental benefits arising from the project.
 The before and after comparison, by contrast, fails to account for
changes in production that would occur without the project, and thus
may lead to an erroneous statement of the benefits attributable to the
project.
3.2. Identification costs and benefits of economic analysis
 3.2.1. Sunk cost
 For both financial and economic analysis, the past is the past.
 What matters are future costs and future benefits.
 Costs incurred in the past are sunk costs that cannot be
avoided.
 When analysing a proposed project, sunk costs are ignored.
 Economic and financial analyses consider only future returns
to future costs.
 To save resources, it is preferable to stop a project midway
whenever the expected future costs exceed the expected
future benefits.
 On the other hand, although stopping a partially completed project
may be more economical than finishing it, closing a project is often
costly.
 Exercise
 Consider your self as an advisor to a president of MeU or
you are the new president of the MeU. Note that there is an
on going project in the CBE. If there is a change of authorities
and one of the decision problem faced by the new president
is whether to proceed with the investment or to stop it.
 i. What is the general approach of dealing with the sunk
costs?
2. Given the fact that already spent investment is Birr 150,000
and the additional investment cost required to complete the
project is Birr 180,000 and the total benefit of the project after
its completion is Birr 200,000
 What should be the decision? Should we proceed with the
investment or stop the investment? Why?
 Initial investment=sunk cost=150,000 and additional
investment=180,000 and total benefit after
completion=200,000.
 180,000<200,000 C < B
 So proceed with the investment. Why net benefit is greater
than Incremental cost of 180,000.
 3.2.2. Transfer payments, externalities and others
 Transfer payments
 Transfer payments 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.
 Thus transfer payments are payments made among different persons/economic
agents/ but they are not related to any particular resources cost.
 So they do not reflect changes in the national economy.
 Hence transfer payments have to be excluded from all estimates of economic
costs and benefits during the economic analysis of a project.

 Taxes versus User Charges (-T and + Charges)

 Some care must be exercised in identifying taxes.
 Not all charges levied by governments are transfer payments. Some are user
charges levied in exchange for goods sold or services rendered.
 Water charges paid to a government agency, for example, are a payment by
farmers to the irrigation authority in exchange for the use of water.
 Externalities (±)
 A project may have a negative or positive impact on specific
groups in society without the project entity incurring a
corresponding monetary cost or enjoying a monetary benefit.
 For example, an irrigation project may lead to a reduced fish
catch.
 The reduction in fish catch would represent a cost to society that
fishermen would bear, yet the monetary flows of the project entity
would not necessarily reflect this cost.
 Analysts should consider these external effects, known as
externalities, when adjusting financial flows to reflect
economic costs.
 If the cost were measurable in monetary terms, we would
gain an important insight into the incentives that fishermen
would have to oppose the project.
3.3. Determining economic values
Valuation of the Impact of a Project: Pareto Optimality
Vs. the Hicks – Kaldor Compensation Principle
 To evaluate alternative economic situations, we need to have
criteria for evaluating social well-being or welfare (social
welfare function).
 Welfare economics is concerned with the evaluation of
alternative economic situations from the point of the
society’s well-being.
 Welfare analysis is a systematic method of evaluating
economic implications of alternative allocations.
 The standard measure employed in welfare economics to
determine whether a change in resource allocation will result
in people being better off is the Pareto welfare
improvement criterion.
 A Pareto improvement in welfare is said to occur if at least
one person is made better off and no one is made worse
off by a given change in economic conditions.
 3.3.2. Shadow pricing
 A shadow price is a monetary value assigned to currently
unknowable or difficult-to-calculate costs in the absence of
correct market prices.
 Shadow prices can be expressed in two ways:
1. They can all be expressed directly in foreign exchange
units
- valuing all project effects at world prices termed as the
world price numeraire.
- It is a unit of freely convertible foreign exchange valued at
the official exchange rate.
2. They can be expressed in domestic price units termed
as a domestic price numeraire.
 If a domestic price numeraire is adopted the border price of
export products need to be adjusted upwards by a certain factor
(conversion factor).
 Shadow price estimates can be made at two levels:
 Economic analysis
 Social analysis
Which Items should be Revalued?
 I.e. For Which Items to Have Shadow Prices?
 The inputs and outputs for which one has to have shadow prices
can be categorized at least into five categories:
1. Primary factors. There are different categories of labour, land,
natural resources, domestic resources and foreign exchange.
 Land and natural resources are usually valued indirectly through
estimation of their productivity in their alternative uses rather than as
capital values.
 For this reason there is no national parameter calculated for land.
2. Tradable goods: This is undertaken when there is a significant
difference between the border price and the local market price.
3. Non-tradable goods: Where there may be a significant
difference between the local market price and the economic
value
4. Average Estimates relating to particular sectors: here cost
data do not allow further breakdown or where the sector
concerned is not a high priority for further investigation.
5. The Discount rate: the rate at which the future steams of costs
and benefits are brought into common denominator, the present
values.
3.3.3. Traded and Non-traded commodities
 Project outputs (Goods and services) and inputs can be
classified as:
 Non tradable goods
 Tradable goods;

A. Non-Tradable Goods
 The non-tradable goods are goods that do not enter into the
international trade because of their:
 Nature or physical characteristics:
 Perishable and/or bulky goods, goods for which there is only
endogenous taste/demand/ (Like Teff in Ethiopia);
 Economics of trading: cost and/or quality performance of
products;
 Policy barriers that affect international trade.
 Cont’d
 In principle, a good falls into this category if:
 CIF>Market Prices: If the CIF cost or landed price of a good is
greater than the local cost/market prices/, importation of the
same is precluded.
 CIF price represents the direct foreign exchange cost of the
input up to the port of entry
◦ Example: Until recently in Ethiopia, oranges, sugar, cement etc are not being
imported even if there are shortages in the domestic supply because of the
fact that the CIF prices are higher than the domestic market prices.
 FOB prices <Market Prices: If the local costs are greater than the
FOB price, then exportation is precluded.
 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.
 In Ethiopia many goods fail to enter into the international trade
because of cost/price in competitiveness.
◦ Example: many textile and garment and tannery and leather
products (shoes and leather clothes)
 So the non-tradable inputs and outputs of a project cannot be
valued directly at border or world prices.
 Cont’d
 The most important non traded items include:
1. Non traded agricultural products, teff in Ethiopia;
2. Electricity; It is rarely transmitted across frontiers.
3. Transport; usually, inland transportation;
4. Water;
5. Construction;
6. Services; real estate, hotel accommodation, haircuts, and other
services are non-tradable goods;
7. Some industrial products, like cement which is bulky to transport;
8. Land and unskilled labor are always non-tradable goods/factors.
 Technological developments are turning a number of non-
tradable into tradable goods. Following containerization in
the shipping industry bulky products like cement have
become tradable goods.
 For instance, while in Ethiopia cement is non-tradable good
till the present (at least before 2006), it is tradable good in
the Sudan.
Measuring/Revaluation of Non-Tradable Goods: Conversion Factors

 the non-tradable inputs and outputs of the project cannot be

valued directly at border or world prices. So the valuation of
non-tradable goods at world prices consists of a number of
steps.
 Net out taxes from the domestic market price of the commodity;
 The net of taxes price is decomposed into its traded and non-
tradable cost elements. When goods do not enter into international
trade by their very nature decomposing is a pre requisite to their
valuation in terms of world prices.
 For the traded components a border price is available by
definition and they are valued at this price.
 The non-tradable items are further decomposed into
traded and non-tradable and the procedure continues until
in successive rounds the original inputs or outputs are
restated in terms of traded components and labor.
 Cont’d
 But this procedure is cumbersome and 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.
 After one or two rounds, then;
1. the non-tradable components will be valued at the domestic price and
multiplied by a conversion factor,
2. traded components will be valued at border prices and
3. labor at the shadow wage rate.
 So it is recognized that even when non-tradable goods are
decomposed there always remain items that are non-tradable and
for which there is only domestic market.
 Thus some world price equivalent figure needs to be derived for
these non-tradable goods.
 To estimate the accounting prices for all other non-tradable goods
(inputs and outputs) we use conversion factors.
B. Tradable Goods
 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.
 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.
 Examples tradable goods include all kinds of:
 Manufacturing
 Agricultural goods
 Intermediate goods
 Raw materials
 Some services such as tourism and consultancy services
 We can classify tradable goods into two other sub-
categories:
Traded goods: Goods that are either imported or exported
by the country;
Potentially traded goods: goods that the country could
import or export under conditions of free trade, but does not
do so, because of trade barriers such as import duties.
 Cont’d
 In the case of Ethiopia, the most important tradable goods
for detailed considerations in undertaking economic analysis
are:
Petroleum products;
Some major agricultural products (particularly coffee,
chat, wheat, livestock, hides and skins, oilseeds and
pulses);
Nearly all industrial products are traded but it is unlikely
that the issue of their valuation will have a major impact
on the analysis of most public projects in the last decade
or so since the EPRDF government has not been
investing in the industrial sector.
 Cont’d
 There are different types of traded goods.
Imported input;
Locally Produced Import Substitute;
Exported Output;
Diverted Export as an Input.
Simultaneously a good can be both import and export
good
 Valuation of Tradable Goods
 Border Parity Pricing
 Border price is the unit price of a traded good at a country’s border or
point of entry.
 Border prices are either CIF or FOB prices suitably adjusted for internal
transport and other costs, but net of taxes and subsidies.
 A parity price or parity economic value is the price or value of a project
input & output that is based on a border price adjusted for expenses
between border and the project boundary.
 To assess 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.
 Recall that for tradable goods,
1. CIF prices < Domestic market prices;
2. Fob prices > Domestic market prices.
 Cont’d
 CIF price represents the direct foreign exchange cost of the input up
to the port of entry (air port, seaport, land port (eg Moyale).
 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.
 The FOB border price should be netted from handling, transportation
and marketing expenses to arrive at the project site price or
farm/factory gate price.
 The reason for using border prices to measure the economic value of
a project’s tradable inputs can be understood in terms of the
assumption that the international markets are comparatively
competitive and free of distortions.
3.3.6. National parameters and standard conversion factor

 Border prices of tradable goods valued at foreign currency and non-

tradable services (like local transportation) valued in domestic
currency are two prices of two categories of goods.
 There are some important parameters that have general applicability in
the sense that they are used in all projects.
◦ 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-tradable sectors
◦ Some aggregate conversion factors such as consumption conversion
factor, a standard average conversion factor, the discount rate,
◦ Shadow foreign exchange rate, etc.
 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.
 Cont’d
 However, a minimum of the following national parameters
should be estimated:
 The standard conversion factor;
 The shadow exchange rate
 The shadow wage rate; and
 The discount rate
 The standard conversion factor
 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
economic/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.
 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.
 The conversion factor for any item ‘i’ is defined as:
𝑆𝑃𝑖
𝐶𝐹𝑖 =
𝑀𝑃𝑖
 Where
 SPi is the shadow price for the item in question and
 MPi is the market price.
 The Standard Conversion Factor is a summary measure to calculate
accounting prices for non-tradable 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 therefore estimated as 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 given as:

 The rule for the non-tradable goods should be still decomposition and
the SCF should be used only when this is impossible, very difficult or is
not worth the effort.
 3.4. Social cost benefit analysis
 The social cost benefit analysis is a tool for
evaluating the value of money, particularly of public
investments in many economies.
 It aids in decision making with respect to the various
aspects of a project and the design programmes of
closely interrelated project.
 Social cost benefit analysis has become important
among economists and consultants in recent years.
 Features of Social Cost Benefit Analysis
 Assessing the desirability of projects in the public as opposed to the private
sector
 Identification of costs and benefits
 Measurement of costs and benefits
 The effect of (risk and uncertainty) time in investment appraisal
 Presentation of results – the investment criterion.
Cont’d
Stages of Social Cost Benefit Analysis of a Project
1. Determine the financial profitability of the project based on the
market prices.
2. Using shadow prices for the resources to arrive at the net benefit of the
project at economic process.
3. Adjustment of the net benefit for the projects impact on savings and
investment.
4. Adjustment of the net benefit for the projects impact on
income distribution.
5. Adjustment of the net benefit for the goods produced whose
social values differ from their economic values.
Social cost benefit analysis suffer from the following limitations

Social cost benefit analysis suffer from the following limitations.

 The problems of qualification and measurement of social
costs and benefits are formidable.
 This is because many of these costs and benefits are intangible
and their evaluation in terms of money is bound to be subjective.

 Evaluation of social costs and benefits has been completed for

one project, it may be difficult to judge whether any other project
would yield better results from the social point of view.

 The nature of inputs and outputs of projects involving very

large investment and their impact on the ecology and people of
the particular region and the country as a whole are bound to be
differing from case to case.
 Basic Arguments for the Application of Social Cost
benefit Analysis
 It has been indicated that commercial profitability is
measured in terms of the difference between the value of
earnings and costs in a certain period.
 Social cost benefit analysis must go deeper and ask what is
the meaning of profits.
◦ The price offered in the market is not a good guide to social
welfare for it includes the influence of income distribution on
the prices offered.
◦ A project may have influences that work outside the market
rather than through it.
◦ Even in the absence of externalities and consideration of income
distribution commercial profitability may be misleading because
of consumer’s surplus.
 3.5.1. Cost effectiveness measures
 What is cost-effectiveness analysis?
 CEA is a form of economic analysis that compares the relative
costs and outcomes (effects) of different courses of action.
 Cost-effectiveness analysis is distinct from cost–benefit
analysis, which assigns a monetary value to the measure of
effect.
 It measures a benefit of a given project by the change it bears
than monetary unit.
 It directly relates the financial and scientific implications of
different interventions.
 The basic calculation involves dividing the cost of an
intervention in monetary units by the expected job gain
measured in natural units such as number of people got job
opportunity
 Cost-effectiveness analysis also requires comparable units for
measuring costs.
Cont’d
 CEA is used here to determine which alternative is the
cheapest.
 If the benefits are measured in some single no monetary
units
 3.5.2. Weighted cost effectiveness measures

 If the benefits consist of improvements in several dimensions

 It is used to select among methods that have multiple outcomes.
 All evaluation techniques share some common steps. The analyst must:
◦ identify the problem,
◦ consider the alternatives,
◦ select the appropriate type of analysis,
◦ decide on the most appropriate course of action.