Fin650: Project Appraisal Lecture 9 Economic Appraisal of Projects

1. Fin650: Project Appraisal Lecture 9 Economic Appraisal of Projects

2. Lecture 9 • 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

3. Analyzing Economic Costs and Benefits in an Existing Market Producer surplus Consumer surplus

4. Analyzing Economic Costs and Benefits in an Existing Market • 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.

5. Analyzing the Economic Benefits of an Output Produced by a Project • 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?

6. Analyzing the Economic Benefits of an Output Produced by a Project

7. 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)

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

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

10. 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

11. Analyzing the Economic Cost of an Input Demanded by a Project Economic Cost of an Input Demanded by a Project in an Undistorted Market: Inelastic supply

12. 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

13. Analyzing the Economic Cost of an Input (subject to tax) 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

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

15. Class Exercise • 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?

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

17. 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.

18. Valuation of Benefits 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

19. 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.

20. Valuation of Benefits in Distorted Markets

21. Valuation of benefits in Distorted Markets • Natural Monopoly • Four policies • Allow monopoly, deadweight loss abc, monopoly profits=Pmafg. • 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. • Require road authority to set Pc , eliminates deadweight loss, price is less than AC, revenue no longer cover costs, subsidy would be required. • Free access, marginal costs exceed willingness to pay, deadweight loss chQo, no toll revenue, entire construction and operation costs have to be subsidized.

22. 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

23. Valuation of benefits in Distorted Markets

24. Valuation of benefits in Distorted Markets

25. Measuring Costs in Inefficient 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

26. Measuring Costs in Inefficient Markets

27. 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

28. Benefits and Cost of Traded Goods and Services • 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

29. Economic Prices of Traded Goods and Services

30. Economic Prices of Traded Goods and Services

31. Valuing Impacts from Observed Behavior • 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

32. 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

33. Demonstrations • 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

34. Direct Estimation of Demand Curves • 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.

35. Class Exercise I • 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

36. Using a Slope Estimate • 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

37. Social Surplus Gain from Refuse Fee

38. Using an Elasticity Estimate • 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.

39. Extrapolation and Econometric Estimation • 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

40. Market analogy method • 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

41. 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

42. Class Exercise II • 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.

43. Class Exercise III • 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.

44. Market analogy method • 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. 1000 wV(life) = Tk. 1000 V(life) = Tk. 1000 /w, w =1/10,000 V(life) = Tk. 1000 /(1/10,000) = Tk. 10,000,000 • Labor market studies (1/1000) V(life) = Tk. 2000 V(life) = Tk. 2 million

45. Lecture 10 • 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

46. 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

47. Shadow Prices

48. Shadow Prices

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

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