Chapter 14 Social Cost Benefit Analysis

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CHAPTER 14

CHAPTER 14 SOCI

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OUTLINE

•

• Rationale

Rationale

for

SCBA

•

• _UNIDO

_UNIDO

_approach

•

• Net

Net

benefit

in

terms

of

economic

(efficiency)

prices

•

• _Savins

_Savins

_impact

_an!

_its

_val"e

•

• Income

Income

!istrib"tion

impact

•

• _A!#"stment

_A!#"stment

_for

_merit

_an!

_!emerit

_oo!s

•

• $ittle%&irrlees

$ittle%&irrlees

approach

•

• Sha!o'

Sha!o'

prices

•

• SCBA

SCBA

by

financial

instit"tions

•

(3)

Rationale for SCBA

In SCBA the foc"s is on the social costs an! benefits of the pro#ect

*hese often ten! to !iffer from the monetary costs an! benefits of the

pro#ect *he principal so"rces of !iscrepancy are +

• _{&ar,et imperfections}

• _{-.ternalities}

• _{*a.es an! s"bsi!ies}

• _{Concern for savins}

• _{Concern for re!istrib"tion}

• Μ

_{erit 'ants}

(4)

UNIDO Approac

Te UNIDO !eto" of pro#ect apprai$al in%ol%e$ fi%e $ta&e$'

/ Calc"lation of the financial profitability of the pro#ect meas"re! at

mar,et prices

0 Obtainin the net benefit of the pro#ect meas"re! in terms of economic

(efficiency) prices

1 A!#"stment for the impact of the pro#ect on savins an! investment

2 A!#"stment for the impact of the pro#ect on income !istrib"tion

3 A!#"stment for the impact of the pro#ect on merit oo!s an! !emerit

oo!s 'hose social val"es !iffer from their economic val"es

-ach stae of appraisal meas"res the !esirability of the pro#ect from a

!ifferent anle

(5)

Net Benefit$ in Ter!$ of Econo!ic

(Efficienc)* Price$

Sa"o+ Pricin& ' Ba$ic I$$,e$

• Choice of n"meraire

• Concept of tra!ability

• Concept of sha!o' prices

• *a.es

• Cons"mer 'illinness to pay

• *ra!able inp"ts an! o"tp"ts

• Non%tra!able inp"ts an! o"tp"ts

• -.ternalities

• $abo"r inp"ts

• Capital inp"ts

• 4orein e.chane

(6)

Ill,$tration

resently5 a ferry service5 operate! privately5 is bein "se! to cross a river *he

ferry operator chares Rs1 per person It costs him Rs0 per person 365666

persons "se the ferry service (*his means that the n"mber of persons crossin

the river by ferry service thro"ho"t the year is 365666)

*he overnment is consi!erin constr"ction of a bri!e over the river It is

estimate! that after the bri!e is constr"cte! 05365666 persons 'ill cross the

river on the bri!e *he bri!e is e.pecte! to cost Rs 1 million initially an! its

ann"al maintenance cost 'o"l! be Rs /65666 It has an in!efinitely lon life

Once the bri!e is constr"cte! the ferry operator is e.pecte! to close !o'n the

ferry service an! sell the ferry boats for Rs/66566

Re7"ire! + Define the social costs an! benefits of constr"ctin the

bri!e5 ass"min that the monetary fi"res iven in the

(7)

Sol"tion + *he social costs an! benefits of bri!e constr"ction may be !efine! as follo's+

Costs

*hese consists of the follo'in+

/ Constr"ction cost + Rs156665666 (*his is a one%shot cost) 0 &aintenance cost + Rs /65666 (*his is an ann"al cost) Benefits

*hese consist of the follo'in +

/ 8al"e of ferries release! + Rs /665666 ( *his is one%shot benefit)

0 Savins in the cost of ferry operation+ Rs /665666 (*his is an ann"al benefit)

1 Increase in cons"mer satisfaction+ *his is e7"al to 'illinness to pay of 0665666 a!!itional persons 'ho are e.pecte! to "se the bri!e Since the

first a!!itional person is 'illin to pay almost Rs 1 (the chare of the ferry operator) an! the late person is 'illin to pay almost nothin (there is no toll for "sin the bri!e) the averae 'illinness to pay of a!!itional "sers5 ass"min that the !eman! sche!"le is linear5 is Rs /36 So the 'illinness to pay of 0665666 a!!itional persons is is 0665666 . Rs /36 9 1665666

(8)

-ea$,re!ent of te I!pact on Di$tri.,tion

Staes three an! fo"r of the UNIDO metho! are concerne! 'ith meas"rin the val"e of a pro#ect in terms of its contrib"tion to savins an! income re!istrib"tion *o facilitate s"ch assessments5 'e m"st first meas"re the income aine! or lost by in!ivi!"al ro"ps 'ithin the society

4or income !istrib"tion analysis5 the society may be !ivi!e! into vario"s ro"ps *he UNIDO approach see,s to i!entify income ains an! losses by the follo'in+

• ro#ect

• Other private b"siness • :overnment

• ;or,ers • Cons"mers • -.ternal sector

<

*he ain or loss to an in!ivi!"al ro"p 'ithin the society as a res"lt of the pro#ect is e7"al to the !ifference bet'een the sha!o' price an! the mar,et price of each inp"t or o"tp"t in the case of physical reso"rces or the !ifference bet'een the price pai! an! the val"e receive! in the case of financial transactions

(9)

Sa%in&$ I!pact an" it$ /al,e

&ost of the !evelopin co"ntries face scarcity of capital =ence5 the

overnments of these co"ntries are concerne! abo"t the impact of a

pro#ect on savins an! its val"e thereof Stae three of the UNIDO

metho!5 concerne! 'ith this5 see,s to ans'er the follo'in 7"estions+

• :iven the income !istrib"tion impact of the pro#ect

'hat 'o"l! be its effect on savins>

(10)

I!pact on Sa%in&$

*he savins impact of a pro#ect is e7"al to+

∑ ∆Υ

_i

_&S

_i

;here

∆Υ

_i

_{9 chane in income of ro"p i as a res"lt of the pro#ect}

&S

_i

9 marinal propensity to save of ro"p i

-.ample As a res"lt of a pro#ect the income aine! ?lost by fo"r ro"ps

is + :ro"p / 9 Rs /665666 :ro"p 0 9 Rs 36656665 :ro"p 1 9

%Rs0665666 an! :ro"p 2 9 %Rs 2665666 *he marinal propensity to

save of these fo"r ro"ps is as follo's+

&S

_/

9 6635 &S

₀

9 6/65 &S

₁

9 6065 an! &S

₂

9 626

*he impact on savins of the pro#ect is+

/665666 . 663 @ 3665666 . 6/6  0665666 . 606 

2665666 . 626 9 % Rs/5235666

(11)

/al,e of Sa%in&$

r(/%a)

r(/%a)(/@ar)

n%/

(@,)

(/@,)

0

_(/@,)

n

r(/%a)

(/@,)

r(/%a)

(/@ar)

(,%ar)

(/@,)

;here I 9 social val"e of savins (investment)

r 9 marinal pro!"ctivity of capital

a 9 reinvestment rate on a!!itional income arisin

from investment

, 9 social !isco"nt rate

I 9

@

@@

@

9

(12)

Inco!e Di$tri.,tion I!pact

&any overnments rear! re!istrib"tion of income in favo"r of

economically 'ea,er sections or economically bac,'ar! reions as a

socially !esirable ob#ective D"e to practical !iffic"lties in p"rs"in the

ob#ective of re!istrib"tion entirely thro"h the ta.5 s"bsi!y5 an! transfer

meas"res of the overnment5 investment pro#ects are also consi!ere! as

investments for income re!istrib"tion an! their contrib"tion to'ar! this

oal is consi!ere! in their eval"ation *his calls for s"itably 'eihin

the net ain or loss by each ro"p5 meas"re! earlier5 to reflect the

relative val"e of income for !ifferent ro"ps an! s"mmin them

(13)

In eneral5 the 'eiht attache! to an income is iven by the

form"la+

b

n

c

_i

;here w

_i

9 'eiht attache! to income at c

_i

level

b 9 base level of income that has a 'eiht of /

n 9 elasticity of the marinal "tility of income

w

(14)

A"#,$t!ent for -erit an" De!erit 0oo"$

In some cases5 the analysis has to be e.ten!e! beyon! stae fo"r to

reflect the !ifference bet'een the economic val"e an! social val"e

of reso"rces *he !ifference e.ists in the case of merit oo!s an!

!emerit oo!s A merit oo! is one for 'hich the social val"e

e.cee!s the economic val"e 4or e.ample5 a co"ntry may place a

hiher social val"e than economic val"e on pro!"ction of oil beca"se

it re!"ces !epen!ence on forein s"pplies *he concept of merit

oo!s can be e.ten!e! to incl"!e a socially !esirable o"tcome li,e

creation of employment In the absence of the pro#ect5 the

overnment perhaps 'o"l! be 'illin to pay "nemployment

compensation or provi!e mere ma,e%'or, #obs

In case of a !emerit oo!5 the social val"e of the oo! is less than

its economic val"e 4or e.ample5 a co"ntry may rear! alcoholic

pro!"cts as havin a social val"e less than the economic val"e

(15)

Little-irrlee$ Approac

*here is consi!erable similarity bet'een the UNIDO approach an! the $%& approach Both the approaches call for+

/ Calc"latin acco"ntin (sha!o') prices partic"larly for forein e.chane savins an! "ns,ille! labo"r

0 Consi!erin the factor of e7"ity 1 Use of DC4 analysis

Despite consi!erable similarities there are certain !ifferences bet'een the t'o approaches+

/ *he UNIDO approach meas"res costs an! benefits in terms of !omestic r"pees 'hereas the $%& approach meas"res costs an! benefits in terms of international prices5 also referre! to as bor!er prices

0 *he UNIDO approach meas"res costs an! benefits in terms of

cons"mption 'hereas the $%& approach meas"res costs an! benefits in terms of "ncommitte! social income

1 *he stae%by%stae analysis recommen!e! by the UNIDO approach foc"ses on efficiency5 savins5 an! re!istrib"tion consi!erations in !ifferent staes *he $%& approach5 ho'ever5 ten!s to vie' these consi!erations toether

(16)

Sa"o+ Price$

• *he o"tp"ts an! inp"ts of a pro#ect are classifie! into the follo'in

cateories+ tra!e! oo!s an! services5 non%tra!e! oo!s an! services5

an! labo"r

• *he sha!o' price of a tra!e! oo! is simply its bor!er price

• *he sha!o' (or acco"ntin) price of a non%tra!e! item is !efine! in

terms of marinal social cost an! marinal social benefit

(17)

U$e of Con%er$ion Factor$

I!eally5 the acco"ntin price of a non%tra!e! item is !efine! in terms of

marinal social cost an! marinal social benefit In practice5 the

calc"lation of marinal social cost an! marinal social benefit is often a

!iffic"lt tas, As a practical e.pe!ient5 $%& s"est that the monetary

cost of a non%tra!e! item be bro,en !o'n into tra!able5labo"r5 an!

resi!"al components *he tra!able an! resi!"al components may be

converte! into social cost by applyin s"itable social conversion factors

the labo"r componentEs social cost can be obtaine! by "sin social 'ae

rate

(18)

Sa"o+ 2a&e Rate

*he sha!o' 'ae rate is an important b"t !iffic"lt%to%!etermine element in

social cost benefit analysis It is a f"nction of several factors+ (i) the

marinal pro!"ctivity of labo"r5 (ii) the cost associate! 'ith "rbanisation

(cost of transport5"rban overhea!s5 etc)5 an! (iii) the cost of havin an

a!!itional amo"nt committe! to cons"mption 'hen the cons"mption of the

'or,er increases as a res"lt of the hiher income he en#oys in "rban

employment

$%& s"est the follo'in form"la for calc"latin the sha!o' 'ae rate+

SWR

9 c’  /? s (c-m)

;here SWR 9 sha!o' 'ae rate

c’

9 a!!itional reso"rces !evote! to cons"mption

/ /s 9 val"e of a "nit of committe! reso"rce

c 9 cons"mption of the 'ae earner

(19)

Acco,ntin& Rate of Ret,rn

*he acco"ntin rate of ret"rn (interest) is the rate "se! for !isco"ntin

social profits In !eterminin the acco"ntin rate of ret"rn the

follo'in consi!erations sho"l! be borne in min!+

• *he f"t"re social profit for all pro#ects m"st be !isco"nte! in

the same 'ay

• *he acco"ntin rate(s) of interest sho"l! be s"ch that all

m"t"ally compatible pro#ects 'ith positive present social val"e

can be "n!erta,en

• *he acco"ntin rate of interest sho"l! maintain some ,in! of

balance bet'een investment an! investible reso"rces+ too lo'

an acco"ntin rate of interest 'o"l! lea! to over%investment

'ith inflationary effects an! too hih an acco"ntin rate of

interest 'o"l! leave savins "n!er%"tilise! an! res"lt in

(20)

SCBA .) Financial In$tit,tion$

*he all In!ia term%len!in financial instit"tions5 IDBI5 I4CI5 an! ICICI (IDBI an! ICICI have no' become "niversal ban,s) appraise pro#ects primarily from the financial point of vie' =o'ever5 they also scr"tinise pro#ects from the larer social point of vie' ICICI 'as perhaps the first financial instit"tion to intro!"ce a system of economic analysis as !istinct from financial profitability analysis I4CI a!opte! a system of economic appraisal in /FGF 4inally5 IDBI also intro!"ce! a system for economic appraisal of pro#ects finance! by them *ho"h there are some minor variations5 the three instit"tions follo' essentially a similar approach 'hich is a simplifie! version of the $%& approach ;e shall !escribe the appraisal proce!"re follo'e! by IDBI

IDBI5 in its economic appraisal of in!"strial pro#ects5 consi!ers three aspects+ • -conomic rate of ret"rn

• -ffective rate of protection • Domestic reso"rce cost

(21)

Econo!ic Rate of Ret,rn

*he metho! follo'e! by IDBI to calc"late the economic rate of ret"rn may

be !escribe! as a Hartial $ittle%&irrleesE metho! beca"se 'hile

international prices are "se! for val"ation of tra!able inp"ts an! o"tp"ts5 $%

& metho! is not follo'e! in its entirety *he sinificant elements of IDBIEs

metho! are !escribe! belo'+

/ International prices are rear!e! as the relevant economic prices

an!5 hence5 it is necessary to s"bstit"te mar,et prices 'ith

international prices for all non%labo"r inp"ts an! o"tp"ts

0 4or tra!able items5 'here international prices are !irectly available5

CI4 prices are "se! for inp"ts an! 4OB prices are "se! for o"tp"ts

1 4or tra!able items 'here international prices are not !irectly

available an! for non%tra!able items (li,e electricity5 transportation5

etc)5 social conversion factors are "se! to convert act"al r"pee cost

into social cost

(22)

Effecti%e Rate of Protection

*ariffs5 import restrictions5 an! s"bsi!ies are "se! to enco"rae !omestic

in!"stries an! protect them aainst international competition *he e.tent to

'hich a pro#ect is sheltere! is meas"re! by the -ffective Rate of rotection

(-R)  It is calc"late! as follo's+

8al"e a!!e! at !omestic prices % 8al"e a!!e! at 'orl! prices

8al"e a!!e! at 'orl! prices

*his ratio is m"ltiplie! by /66 to e.press the -R in percentae terms

*he !ata re7"ire! for calc"latin the -R may be arrane! as follo's+

At !omestic prices

At 'orl! prices

A Sellin price

B Inp"t cost+ *ra!e!

Non%tra!e!

C 8al"e a!!e!

(23)

Do!e$tic Re$o,rce$ Co$t

Domestic reso"rces cost (DRC) reflects the !omestic cost inc"rre! per "nit of forein e.chane save! or earne! 4inancial instit"tions "se the follo'in form"la to calc"late DRC

A @ B @ C

DRC 9 . -.chane rate

P  (Q @ R @ S @ T )

;here A 9 ann"al chare on !omestic capital calc"late! at the rate of /6 percent

B 9 ann"al !epreciation on !omestic capital assets (other than lan!) calc"late! at the rate of  percent

C 9 ann"al cost of non%tra!e! inp"ts

P 9 sales realisation at international prices

Q 9 ann"al chare on importe! capital assets at the rate of /6 percent

R 9 ann"al !epreciation on importe! capital assets at the rate of  percent

S 9 ann"al cost of importe! inp"ts

(24)

P,.lic Sector In%e$t!ent Deci$ion$ in In"ia

8ery broa!ly the principal steps in the p"blic investment !ecision ma,in process in In!ia are as follo's+

/ *he lannin Commission form"lates the five%year plan in!icatin the

broa! stratey of plannin5 the role of each sector5 the physical tarets to be achieve! by each sector5 an! the financial o"tlays to be ma!e available for the !evelopment of each sector

0 *he a!ministrative ministries !evelop sectoral plans It is in these plans that

the pro#ects of the p"blic sector enterprises are i!entifie! *he i!entification of a pro#ect provi!es the reen sinal for the preparation of its feasibility report

1 *he concerne! p"blic sector enterprise prepares the feasibility report an!

for'ar!s it to its a!ministrative ministry

2 *he a!ministrative ministry carries o"t a preliminary scr"tiny of the

feasibility report an! sen!s copies of the same to the vario"s appraisin aencies5 namely5 the lannin Commission5 the Department of -conomic Affairs an! the lan 4inance Division of the 4inance &inistry5 an! the B"rea" of "blic -nterprises for their comments

(25)

3 *he AD of the lannin Commission carries o"t a !etaile! appraisal

*he ob#ective of its appraisal is not only to s"est 'hether to accept

or re#ect the pro#ect b"t also to s"est ho' it may be re%form"late! to

enhance its technical5 financial5 commercial5 an! economic viability

J *he Investment lannin Committee of the lannin Commission

!isc"sses the appraisal note of the AD an! recommen!s to the IB

the vie' of the lannin Commission on 'hether the pro#ect sho"l! be

accepte!5 re#ecte!5 !eferre!5 reform"late!5 or re!esine!

G *he IB consi!ers the (a) appraisal note of the AD alon 'ith the

vie' of the plannin Commission5 (b) the comments of the B-5 (c)

the comments of the plan finance !ivision of the ministry of finance5

an! (!) the note of the a!ministrative ministry If the IB clears the

pro#ect5 it sen!s it to the cabinet for its approval

 *he cabinet enerally accepts the recommen!ation of the IB an!

approves its implementation

(26)

SU--ARY

 In SCBA the foc"s is on social costs an! benefits of a pro#ect *hese often ten! to

!iffer from the costs inc"rre! in monetary terms an! benefits earne! in monetary terms by the pro#ect *he principal reasons for !iscrepancy are+ (i) mar,et imperfections5 (ii) e.ternalities5 (iii) ta.es5 (iv) concern for savins5 (v) concern for re!istrib"tion5 an! (iv) merit an! !emerit oo!s

 *o'ar!s the en! of the si.ties an! early seventies t'o principal approaches for

SCBA emere! + UNIDO approach an! $ittle% &irrlees approach

 *he UNIDO metho! of pro#ect appraisal involves five staes+ (i) calc"lation of the

financial profitability of the pro#ect meas"re! at mar,et prices (ii) obtainin the net benefit of the pro#ect meas"re! in terms of economic (efficiency) prices (iii) a!#"stment for the impact of the pro#ect on savins an! investment (iv) a!#"stment for the impact of the pro#ect on income re!istrib"tion an! (v) a!#"stment for the impact of the pro#ect on merit an! !emerit oo!s

 As per the $%& approach5 the o"tp"ts an! inp"ts of a pro#ect are classifie! into the

follo'in cateories+ (i) tra!e! oo!s an! services5 (ii) non%tra!e! oo!s an! services5 an! (iii) labo"r

(27)

 *he sha!o' price of a tra!e! oo! is simply its bor!er price If a oo! is e.porte!

its sha!o' price is its 4OB price an! if a oo! is importe! its sha!o' price is its CI4 price *he sha!o' prices for non%tra!e! items are !efine! in terms of marinal social cost an! marinal social benefit

 *he $%& approach s"ests the follo'in form"la for calc"latin the sha!o'

'ae rate (S;R) SWR 9 c’  /? s (c-m)

 ;hile the all%In!ia term%len!in instit"tions  IDBI5 I4CI5 an! ICICI% approach

pro#ect proposals primarily from the financial point of vie'5 they also eval"ate them from the larer social point of vie'

 *ho"h there are some minor variations5 the three instit"tions follo' essentially a

similar approach 'hich is a simplifie! version of the $%& approach

 IDBI5 the ape. term%len!in financial instit"tions5 consi!ers three aspects in its

economic appraisal of in!"strial pro#ects+ economic rate of ret"rn5 effective rate of protection5 an! !omestic reso"rce cost

 *he economic rate of ret"rn is simply the internal rate of ret"rn of the stream of

social costs an! benefits

 *he effective rate of protection is calc"late! as follo's+ 8al"e a!!e! at !omestic

(28)

 *ill the mi!!le of the si.ties the mechanism for appraisal an! selection of p"blic

sector pro#ects 'as rather primitive *o improve the 7"ality of pro#ect plannin an! strenthen the p"blic investment !ecision ma,in process several steps 'ere ta,en+ creation of the B"rea" of "blic -nterprises establishment of the ro#ect Appraisal Division (AD) in the lannin Commission an! instit"tion of the "blic Investment Boar! (IB)