Dev 567Project and Program Analysis

Lectures 6: Economic Appraisal of Projects

Dr. M. Fouzul Kabir KhanProfessor of Economics and Finance

North South University

• Analyzing economic costs and benefits in an existing market

• Evaluation of costs and benefits in distorted markets• Direct estimation of demand curve• Extrapolation and econometric estimation

Lecture 6

Analyzing Economic Costs and Benefits in an Existing Market

Price in Rand/Unit Price in Rand/Unit

Units of Output Units of Output

Pmax Pmax

Pm

0 Qm

C Pm

Qm 0

C

Demand

Supply

E

(a) Total Economic Benefit (b) Total Economic Cost

Units of Output

Price in Rand/Unit

Pmax

Pm C

0 Qm

Demand

Supply

E

(c) Total Economic Benefits and Costs

Producer surplus

Consumer surplus

The gross economic benefits from the consumption of the output from this industry are greater than the financial revenues received by the suppliers due to the consumer surplus enjoyed by the consumers of the output.

Economic cost of producing the output is less than the financial revenues received by the suppliers due to the producer surplus enjoyed by the suppliers.

The implication of these two facts is that the financial price of a unit may be different from its economic price even in the absence of distortions.

Analyzing Economic Costs and Benefits in an Existing Market

Valuing Project outputs Will depend on the nature of the market in which the output is traded.

Elastic demand, or a small project Use market price Quantity supplied by the project *market price

Perfectly inelastic supply Use average of before and after project prices, area under the demand

curve in the range of change in project output. How to find price after the project?

Analyzing the Economic Benefits of an Output Produced by a Project

Analyzing the Economic Benefits of an Output Produced by a Project

Analyzing the Economic Benefits of an Output Produced by a Project

Economic Benefits of a New Project in an Undistorted Market:Upward sloping supply (a large project)

Analyzing the Economic Benefits of an Output Produced by a Project

Analyzing the Economic Benefit of an Output (subject to tax) Supplied by a Large Project

• If the quantity demanded by the project is relatively small compared

to the size of the market then there will only be a very small change

in the market price.

• In such a situation and given that we are operating in an undistorted

market, the gross financial cost to the project will be equal to the

gross economic cost.

• A difference only arises when the change in the quantity demanded

by the project is sufficiently large to have a large impact on the

prevailing market price.

Analyzing the Economic Cost of an Input Demanded by a Project (Cont’d)

Analyzing the Economic Cost of an Input Demanded by a Project

Economic Cost of an Input Demanded by a Project in an Undistorted Market: Elastic supply, large market or a small project

)(*2

'21 qqPP

)(*2

'2 qqPPres

Analyzing the Economic Cost of an Input Demanded by a Project (Cont’d)

• If the quantity demanded by the project is large compared to the size of the market then there will only be a change in the market price.

• Government purchasing land

– Purchase price, P2*(q-q1)

– Economic costs • Land taken through eminent domain

– Economic costs

Economic Cost of an Input Demanded by a Project in an Undistorted Market: Inelastic supply

Analyzing the Economic Cost of an Input Demanded by a Project

Economic Cost of an Input Demanded by a Project in an Undistorted Market: Upward sloping supply curve and a large Project

Analyzing the Economic Cost of an Input Demanded by a Project

• Large project subject to purely revenue generating input tax

• General principles:

– When a project reduces the quantity of input available for other people, use the willingness to pay (as indicated by the demand curve) as value

– When a project increases the quantity of input that the market must produce, use marginal cost for the value of the added input

– Tax is treated as transfer

Analyzing the Economic Cost of an Input (subject to tax) Demanded by a Project

Analyzing the Economic Cost of an Input (subject to tax) Demanded by a Project

A project uses large quantity of cements to build a bridge. Cements are subject to a Tk. 1/bag tax and 100 million bags will be used to build the bridge. As a result of the bridge, the price of cement including the tax, will rise to from Tk. 2 to Tk. 2.30 per bag and private consumers are expected to decrease their consumption by 20 million bags. What costs should be attached to this input?

Class Exercise

Analyzing the Economic Cost of an Input (subject to taxes related to externalities) Demanded by a Project

• 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.

Economic Evaluation of Non-Tradable Goods and Services in Distorted Markets

• If market or government failures distort the relevant product market, then project benefits are measured by the changes in social surplus resulting from the project plus net revenues generated by the project

• Monopoly– As in the competitive case, the social surplus generated by

the output produced and sold in the monopolist is represented graphically by the area between the demand schedule and the marginal cost curve that is to the left of the MR and MC curves

Valuation of Benefits in Distorted Markets

◦ Social surplus above the price is received by the consumers and that below the price is captured by the producer.

◦ Monopolist is a part of the society; therefore benefits accruing to them count.

◦ Breaking the monopoly will increase social surplus;

Deadweight loss would disappear. Consumers will capture a part of the monopolists

producers surplus, viewed as transfer.

Valuation of Benefits in Distorted Markets

Valuation of Benefits in Distorted Markets

Natural Monopoly Four policies

1. Allow monopoly, deadweight loss abc, monopoly profits=Pmafg.

2. Regulate monopoly, set PR = AC, eliminates monopoly profits, transferring

social surplus to persons using the road, expands output, reduces deadweight loss from area abc to area dec, society’s benefit adeb.

3. Require road authority to set Pc , eliminates deadweight loss, price is less

than AC, revenue no longer cover costs, subsidy would be required.

4. Free access, marginal costs exceed willingness to pay, deadweight loss chQo, no toll revenue, entire construction and operation costs have to be

subsidized.

Valuation of benefits in Distorted Markets

Information Asymmetry Externalities

Negative Externality

Too low price, too much output, deadweight loss Impose tax t Social accounting ledger

Positive Externality

Too high price, too little output Provide subsidy v Social accounting ledger

Public goods Little or none will be produced, willingness to pay, optimal level of output of public goods

Valuation of Benefits in Distorted Markets

Valuation of benefits in Distorted Markets

Valuation of benefits in Distorted Markets

Valuation of benefits in Distorted Markets

Purchase at below opportunity costs e.g. witnesses, commuting costs, lost labor

Hiring unemployed labor Five alternative measures of social cost of hiring unemployed labor

Zero opportunity costs, other productive work, value of leisure, value of time: Pe, Pc,Pd, Pd, Pr. Opportunity cost should be non-zero

Budgetary expenditure, workers were willing to work for less, subtract producers surplus, transfer to the workers

Area cdLdLt

½(Pm+Pr)(L’)

½(Pm)(L’), assumes Pr to be zero Purchases from a monopolist

Measuring Costs in Inefficient Markets

Measuring Costs in Inefficient Markets

The general rule In factor markets in which supply is taxed, direct expenditure outlays

overestimate opportunity cost In factor markets in which supply is subsidized, direct expenditure outlays

underestimate opportunity cost In factor markets exhibiting positive externalities of supply, expenditures

overestimate opportunity costs In factor markets exhibiting negative externalities of supply, expenditures

underestimate opportunity costs

Opportunity cost equals direct expenditure in the factor

market minus (plus) gains (losses) in social surplus

Occurring in the factor market

Measuring Costs in Inefficient Markets

• Trade effects of outputs– Extra export– Less imports– A combination of the two

• Trade effects of inputs– More imports– Less exports– A combination of the two

• Economic benefit of exported/importable output• Economic cost of imported/exportable input

Benefits and Cost of Traded Goods and Services

Economic Prices of Traded Goods and Services

Economic Prices of Traded Goods and Services

• In project analysis we estimate change in social surplus to value impact of the program/project

– Need to know the shapes of the supply and demand curves

• There are well functioning competitive markets, know only one point on the demand and supply curves, represented by the equilibrium

Valuing Impacts from Observed Behavior

• Goods that are rarely traded in markets-health and safety, pollutions, access to scenic areas

• Commodities that are traded in imperfect markets, monopoly, asymmetric information, and externalities

Valuing Impacts from Observed Behavior

• Estimating benefits and cost based on demonstration or pilot programs.• Alternative evaluation designs:

– Classical experimental design with or without baseline data– Simple before and after comparison

– Non-experimental comparison with or without baseline data

• Limited applications:– Employment and training programs, people oriented service– A new dam, on a small scale, pilot basis cannot be done

• Advantages:– A bad idea can be abandoned– Needed adjustment in the program may be made

• Disadvantages:– May not readily translate into a large-scale program

– Uncertainty concerning external validity

Demonstrations

Three possibilities• Knowing one point on the demand curve and its

slope or elasticity.• Extrapolating from a few points, know a few points

on the demand curve that can be used to predict another point of relevance to policy evaluation. • Econometric estimation with many observations,

have a sufficient number different observations of prices and quantities.

Direct Estimation of Demand Curves

• Current refuse disposal is 2.6lbs per person per day and disposed off in containers of 20lbs

• Currently there is no charge on refuse collection• Marginal social cost (collection + landfill costs) = 0.6/lb• In new Delhi for each Rupee increase in price of refuse

collection reduces wastes by 0.4 lb/p/d• Assume a linear demand curve• Evaluate impact of imposition of a fee of 0.05/lb, i.e. Tk. 1

for each container of 20lbs, MPC is less than MSC

Exercise

pq 10 Linear demand curve

Slope or elasticity estimates from previous research Assuming α0 = 2.60, α1= - 0.4 Estimating social surplus gain from charging for refuse

disposal ◦ A graphical illustration

Using a Slope Estimate

Social Surplus Gain from Refuse Fee

• We have an estimate of price elasticity of demand from previous research– εd = α1 p/q

– α1 = εd q/p

– εd=-0.12

– p = 0.81, and q = 2.62, α1 = -0.40

• Construction of a linear demand curve to measure changes in social surplus requires either a direct estimate of the slope itself or an estimate of the price elasticity of demand and the price and quantity at which the elasticity was estimated.

Using an Elasticity Estimate

• Effect of a fare increase on bus ridership– If the past fare increase of Tk. 1 resulted in 1000 fewer riders , then it may be

reasonable to assume that a further increase of Tk.1 will have the same effect– Assumed functional relationship between the outcome and the policy variable

• Linear functional forms can produce very different predictions than constant-elasticity functional forms

• Further we extrapolate from past experience, the more sensitive are our predictions to assumptions about functional form

• Econometric estimation with many observations– If many observations of quantities demanded at different prices are available,

then it may be possible to use econometric techniques to estimate demand schedule

Extrapolation and Econometric Estimation

• Government supply many goods that are also provided by the private sector, e.g. education

• Using price and quantity of an analogous private sector good to estimate the demand curve for a publicly provided good

• The market price of a comparable good in the private sector is an appropriate shadow price for a publicly provided good, if it equals the average amount that users of the publicly provided good will be willing to pay– Private and public goods must be comparable in quality of service and other

important characteristics– Limitations:

• Using private sector revenues would underestimate benefits, because it omits consumer surplus

Market analogy method

• Using the market analogy method to value time saved– Bridge, highway improvement saves time– Wage rate– Limitations of wage rate

• Benefits, should be added to wages• People work during travel• Truck drivers work, to be counted,

wage + benefit• Taxes, After tax wage rate plus benefit• Pleasure travel• Dirty, dangerous jobs, unemployed

Market analogy method

Using Airbags in car would increase probability

of survival in a accident from p to p + w.

Additional cost of an airbag is Tk.1,000

W=1/1000

Calculate value of life.

Exercise I

One type of construction job has a 1/1000 greater chance of a fatal injury in a year than another type of construction job.

Suppose riskier job pays a salary that is Tk. 2000 higher than the safer job

Calculate value of life.

Exercise II

Using the market analogy method to value life saved– Foregone earnings method

• Value of life saved equals the present value of future earnings– Consumer purchase studies

(p+w)V(Life) –Tk. 1000 = pV(life)(p+w)V(Life) - pV(life) = Tk. 1000wV(life) = Tk. 1000V(life) = Tk. 1000 /w, w =1/10,000V(life) = Tk. 1000 /(1/10,000) = Tk. 10,000,000

– Labor market studies(1/1000) V(life) = Tk. 2000 V(life) = Tk. 2 million

Market analogy method

Intermediate good method– If the output from a project is to be used as an input into the production of

some other good, then the effects on profits of the other, downstream industry can be included as a benefit, e.g. irrigation, education and training, value added

• Excludes consumer surplus• Double counting, demand curve for water, benefits to farmer

Asset valuation method– Increase or decrease in the property value following implementation of a

project, e.g. location of jail, park • Ex post CBA• Assumes other factors remaining the same• Not applicable in case of mobile assets

Intermediate Good and Asset Valuation Method

• Used in valuing recreational sites• Steps in travel cost method

– Visitors from different origins bear different travel costs depending on their proximity to the site

– The resulting differences in total cost, and the differences in the rates of visit that they induce provide a basis for estimating demand curve for the site

– Select a random sample of households within the market area of the site– Survey the households to determine their number of visits to the site over

some period of time, all of their costs involved in visiting the site, the cost of visiting substitute sites, their incomes, and their other characteristics

– Specify a functional form for the demand schedule and estimate it using the survey data

Travel Cost Method

Zone Travel Time

(hours)

Travel Distance

(km)

Actual total

cost per person

(Tk.)

Average number of Visits

per Person

ConsumersSurplus per

Person

ConsumersSurplus per Zone (Tk.

thousands)

Trips per Zone

(thousands)

A 0.5 2 20 15 525 5,250 150

B 1.0 30 30 13 390 3,900 130

C 2.0 90 65 6 75 1,500 120

D 3.0 140 80 3 15 150 30

E 3.5 150 90 1 0 0 10

Total 10,800 440

Illustration of the Travel Cost Method

Travel Cost Method