MZUMBE UNIVERSITY

FACULTY OF SOCIAL SCIENCES

DEPARTMENT OF ECONOMICS

MSc. PROJECT PLANNING AND MANAGEMENT

ECONOMIC ANALYSIS OF PROJECTS (ECO 603)

2013/2014
TERM PAPER

STUDENT: RODRICK WILBROAD MUGISHAGWE

REG. NUMBER: MSC/PPM/MZC/030/T.13
INSTRUCTOR: DR. NGILANGWA
TASK: INDIVIDUAL ASSIGNMENT

TOPIC
DISCUSSION ON THE THREE MAIN APPROACHES TO ECONOMIC
ANALYSIS OF PROJECTS

SUBMISSION DATE: MAY 2014

LIST OF ABBREVIATIONS
C.I.F

- Cost, Insurance and Freight

CBA

- Cost Benefit Analysis

F.O.B

- Free On Board

GNP

- Gross National Product

L-M

- Little Mirrlees

NSB

- Net Social Benefit

OER

- Official Exchange Rate

SCBA

- Social Cost Benefit Analysis

SER

- Shadow Exchange Rate

S-VT

- Squire and Van de Tak

UNIDO

- United Nation Industrial Development Organization

TABLE OF CONTENTS
2. OBJECTIVES OF ECONOMIC ANALYSIS...................................................................i
3. METHODS OF ECONOMIC ANALYSIS ......................................................................ii
3.1. UNIDO APPROACH ..............................................................................................ii
3.3. SQUIRE AND VAN DE TAK (S-VT) APPROACH..................................................x
4. RELATIONSHIPS BETWEEN APPROACHES OF ECONOMIC ANALYSIS ............xiv
5. APPLICATIONS OF ECONOMIC APPRAISAL METHODS IN TANZANIA................xvi
REFERENCES...............................................................................................................xx

1. INTRODUCTION

Over the years there has been a general consensus among many international institutions,
academicians, politicians and economists that market prices, broadly defined, are not
reliable guides with which to evaluate social costs and benefits of projects. This
agreement is based on a generally accepted doctrine that any departure from the perfectly
competitive paradigm may cause prices to diverge from marginal cost. The theoretical
development of the literature on economic analysis model is based on the theory of
welfare economics, according to which the welfare of a society depends on the aggregate
individual utility levels of all members of that society. Economic analysis had, at first,
used for evaluating public investments in the decade of 1960s and 1970s. In those
decades, this model had got a good emphasis; because public investments in many
countries, especially in developing countries, were immensely increased. Of recent,
economic analysis is also becoming important for private project as more often there is a
possibility for this kind of projects to bring adverse impact to the society.
2. OBJECTIVES OF ECONOMIC ANALYSIS
The objective of economic analysis to secure and achieve the value of money in
economic life by evaluating the costs and benefits of alternative economic choices and
selecting an alternative which offers the largest net benefit to the community. Therefore,
it can be said that the main focus of economic analysis is to determine:
1. Economic benefits of the project in terms of a price (shadow price) that reflect
social value.
2. The impact of the project on the level of savings and investments in the society.
3. The impact of the project on the distribution of income in the society.
4. The contribution of the project towards the fulfilment of certain merit wants (selfsufficiency, employment etc).

3. METHODS OF ECONOMIC ANALYSIS

It may be noted, in this context, that the actual cost or revenues from the goods and/or
services to the organization do not necessarily reflect the monetary measurement of the
cost ant or benefit to the society. This is because these figures are grossly distorted on
account of restriction and controls imposed by the government. Hence a different
yardstick has to be used for evaluating a particular in terms of cost and sacrifice on the
part of the society. Such payments are easily valued at opportunity cost or shadow prices
to judge their real impact in terms of cost to society for the purpose of social cost benefit
evaluation. There are essentially three mainstream and complete works on project
appraisal and shadow pricing, advocated for use in developing countries. These are the
procedures suggested by Little & Mirrlees in 1969 and 1974, The UNIDO by Dasgupta,
Marglin and Sen in 1972 and Squire and Van de Tak in 1975.
3.1. UNIDO APPROACH
UNIDO was designed by three economists Dasgupta, Marglin and Sen who come up with
useful publications dealing with the problem of measuring social costs and social
benefits. The UNIDO guidelines provide a comprehensive framework for appraisal of
projects and examine their desirability and merit by using different yardsticks in a stepwise manner. The desirability is examined from various angles, such as the impact on;
financial profitability of utilization of domestic resources, savings and consumption
pattern, income distribution, and production of merit and demerit goods. These different
aspects are examined in five stages, each stage leading towards a social benefit-cost of
the project.
Stage one
Measures financial profitability from detailed integrated standard analytical tables
enumerating various costs and benefits at the market price and examines profit viability
from investors point of view. A good technical and financial analysis must be done
before a meaningful economic evaluation can be made. For this reason, financial
profitability is a prerequisite in all cases. Financial profitability produces an estimate of
the projects financial profit or the net present value of the project when all inputs and
ii

outputs are measured at market prices. The first step in stage one is to complete standard
tables of income statement, balance-sheet and cash-flow. The financial income statement
is the central table in this analysis as it is used to record the inputs and outputs of the
project. Cash flow statement is also important here as the financial income statement only
shows the annual profit and disguise investment. The net cash flow is derived from the
financial income statement by standard accounting procedures and is equal to the gross
cash flow (operating profit before interest and taxes plus allowances for depreciation)
minus capital investments.
Net Present value of a Project is calculated as:
T

NPV =
t =0

Vt Ct
I0
(1 + K ) t

(3.1)

Where
Vt = Value of outputs at market price at time t
Ct = Value of inputs at market price at time t
K = Discount Rate
T = Lifetime of the project
I0 = Initial cost at the start of the project.

The project is viewed as financially feasible if NPV > 0.

Stage two
Stage two of the UNIDO approach adjusts the financial costs and benefits to various
distortions introduced by market imperfections by valuing costs and benefits or net
benefits in terms of economic efficiency or shadow prices. Market prices represent
shadow prices only under conditions of perfect markets which are almost invariably not
fulfilled in developing countries. Hence, there is a need for developing shadow prices and
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measuring net economic benefit in terms of these prices. For shadow prices, it categorizes
project inputs and outputs into traded, tradable and non-traded. For traded and
tradable, the guidelines use the border prices as the relevant shadow prices, whereas nontraded inputs and outputs are broken down into their components and each tradable
subcomponent is valued at border prices, and so on. The residual non-traded components
of commodities are valued at domestic willingness to pay criterion and the labour is
valued at shadow wage rate.
Calculating Net-benefit of the project from social point of view by:
T

NPV =
t =0

Vt Ct
I0
(1 + K ) t

(3.2)

Where,
Vt = Shadow price of Benefit at time t
Ct = Shadow price of Operating Expenses at time t
K = Social Discount Rate
T = Lifetime of the project
I0 = Initial cost at the start of the project.
Stage three
Most of the developing countries face scarcity of capital. Hence, the governments of
these countries are concerned about the impact of a project on savings and its value
thereof. This stage designed to examine the impact of projects on savings and
consumption which are of vital consideration in the choice of alternative investments in
labour-intensive and capital-intensive projects. If saving is assigned great importance, as
should be the case in capital-scarce countries, this stage recommends the rate for
adjustment for savings by which the social value of a dollar investment exceeds its
consumption value.

iv

NS = Yi MPSi

(3.3)

Where,
NS = Net savings impact of a project
Yi = change in income of group i as a result of the project
MPSi = marginal propensity to save of group i

Adjustment Factor for Savings (AFs)

AFs measure the percentage by which the social value of investment exceeds social value
of consumption.
AFs =

MPC MP
1
CRI MP MPS

(3.4)

Where,
MPC = Marginal Propensity to Consume
MPS = Marginal Propensity to Saving
MP = Marginal Productivity of Capital
CRI = Consumption Rate of Interest (social discount rate)

Stage four
Many governments regard redistribution in favour of economically weaker sections or
economically backward regions as a socially desirable objective. Due to practical
difficulties in pursuing the objective of redistribution entirely through the tax, subsidy,
and transfer measures of the government, investment projects are also considered as
investments for income redistribution and their contribution toward this goal is
considered in their evaluation this calls for suitably weighing the net gain or loss by each
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group, measured earlier, to reflect the relative value of income for different groups and
summing them.
When more than two groups are involved, weights are calculated by the elasticity of
marginal utility of income. The marginal utility of income is the weight attached to an
income is:
b
wi =
ci

(3.5)

Where,
wi = weight of income at ci level
ci = level of income of group i
b = base level of income that has a weight of 1.00
n = elasticity of the marginal utility of income

Stage five
In stage five, the UNIDO analysis suggests a methodology for necessary adjustment of
the deviations in economic and social values and difference between the efficiency and
social value of project output, say, between good and bad or merit and demerit goods. It
has been claimed that the analysis of merit and demerit goods is not designed for purists
in economics who think that economics should be devoid of political or subjective
judgements (UNIDO 1978). The steps of adjustment procedure are:

Estimating the present economic value

Calculating the adjustment factor

Multiplying the economic value by the adjustment factor to obtain the adjusted
value
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Adding or subtracting the adjusted value to or from the net present value of the
project as calculated in stage four.

The figure below illustrates the concept of the UNIDO shadow exchange rate. Suppose
trade distortions keep the domestic currency overvalued, so that OER is below the
equilibrium exchange rate E.

The willingness-to-pay for foreign exchange at the margin is given by SER. This is the
price that people are willing to pay in order to acquire the foreign exchange with which to
buy imports or, alternatively, the foreign exchange that is made available from exports.
Given the SER, the benefit of any project under the UNIDO approach may be expressed
as follows:
NB = SER (X - M) D

(3.6)

Where NB = net benefits

SER = Shadow Exchange Rate
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X = Export
M = Import
D = Value of domestic inputs

3.2. LITTLE MIRRLEES (L-M) METHOD

The core of this approach is that the social cost of using a resource in developing
countries differs widely from the price paid for it. Hence, it requires shadow prices to
denote the real value of a resource to society. L-M measures the cost and benefits in
terms of international or border prices because the border prices represent the correct
social opportunity costs or benefits of using or producing traded goods. L-M also
suggested an elaborate methodology for calculating shadow prices of non-tradable.
L-M believe that in all less developed countries, one of the major criteria for the choice
of a project should be its ability to generate savings and, hence, the L-M method suggests
the use of accounting rate of interests to calculate present worth of future annuities of
savings and consumption. The numeraire in the L-M system is defined as uncommitted
government income, which is expressed in terms of border prices by converting into
domestic currency at the official exchange rate (OER). Border or world prices are
preferred under the L-M methodology as they represent a set of opportunities open to a
developing country, given the availability of scarce foreign exchange resources. In this
perspective, traded goods are valued at border prices, with the accounting price of an
export equal to its f. o. b. price. The accounting price of an import is equal to its c.i.f.
value. Where additional exports or imports are likely to influence their respective prices,
the f.o.b. and c. i. f. prices are replaced by marginal export revenue and the marginal
import prices, respectively. The resources (inputs and outputs) of a project are classified
under L-M into mainly; Labour, traded goods and non-traded Goods. Therefore, to find

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out the real value of these resources, L-M calculates the shadow wage rate (SWR),
shadow price of traded and non-traded goods.
The valuation of non-tradable at border prices in the L-M system requires a little more
ingenuity. Non-tradable are valued by decomposing their marginal cost of production into
primary domestic inputs (mainly labour), traded and non-tradable goods. Primary inputs
are then valued at their shadow prices; traded goods are valued at border prices; and nontradable goods are iteratively decomposed into the same three components until every
input of the non-tradable good is expressed in terms of primary inputs and/or tradable
goods. This procedure is performed using input-output analysis. The net impact of a
project under the L-M procedure may be expressed as follows:
NB = (OER) (X - M) D

(3.7)

Where NB = net benefits

OER = official exchange rate
X = export at f.o.b
M = import at c.i.f
D = value of domestic inputs
= standard conversion factor.
The purpose of computing the shadow wage rate (SWR) is to determine the opportunity
cost of employing an additional worker in the project. For this reason we need determine
the value of the output foregone due to the use of a unit of labour and the cost of
additional consumption due to the transfer of labour. L-M suggests the following formula
for calculating the SWR.
SWR = m + (c- c) + (1-1/s) (c-m)

(3.8)

Where
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SWR= Shadow wage rate

m = marginal productivity of the wage earner
c= additional resources devoted to consumption
c = consumption of wage earner
1 = value of uncommitted resources
1/s = value of committed resources
Supporters of the L-M procedure favour it for its analysis of projects explicitly in terms
of scarce foreign exchange. As a result it allegedly offers a better reflection of trade
efficiency of economic planning in developing countries. The reasoning is that the use of
border pries reflects a country's actual terms of trade.
3.3. SQUIRE AND VAN DE TAK (S-VT) APPROACH
This is the third methodology of appraisal, which draws heavily on the L-M and
incorporates certain aspects of the UNIDO assumption. It has two distinctive features.
One, it bases the economic evaluation on a consistent shadow pricing system, and, two, it
incorporates distributional considerations into the analysis. The S-VT procedure suggests
a two - step approach to the estimation of accounting prices. The first step involves the
derivation of efficiency prices, while the second step is concerned with the estimation of
social accounting prices.
Efficiency pricing
Efficiency accounting prices are those prices that are obtained on the sole basis of
resource allocation considerations. There are four implicit assumptions in the estimation
of efficiency prices. These are a) that the actual rate of growth in the economy is optimal
and desired savings is equal to desired investment b) the economy is not faced with a
foreign exchange constraint; c) the distribution between public and private sector
investments is optimal; and d) the distribution of income is optimal - i.e., an additional
unit of consumption is equally valuable to rich and poor. The net benefit of a project
is described by an equation similar to (3.7) above.

NB = OER (X M) - kDk

(3)

Where k is the conversion factor for each particular group of inputs from domestic to
border prices, and Dk is composed of domestically-produced commodities that are close
substitutes to tradable goods as well as non-traded goods. The parameter can be viewed
as the variable which translates the value of the whole basket of domestically produced
goods into border prices by adjusting distortions in each price. The border price
equivalent to the tradable component of Dk may be derived by allowing for tariffs and
other distortions. For the other non-tradable component of Dk, which consists of primary
factor inputs, specific conversion factors k are derived by considering the value of
output (in border prices) that is foregone by employing these inputs in a particular
project. The conversion factors of other non-tradable inputs, such as construction,
electricity etc, may be derived similarly by decomposing them into traded goods and
primary inputs, and evaluating them accordingly.
The standard conversion factor in equation (2) is therefore a weighted average of the
specific conversion factors k. They are weighted by their share of the total domestic
input given a particular project -i.e. = k/Dk. The fact that k is in principle projectspecific constitutes a very significant deviation from the UNIDO approach in which the
SER is calculated on the basis of nationwide weights (the weight of tradables and nontradeables in the Gross National Product).
Social accounting pricing
Linn (1977) has argued that the contrast between efficiency and social pricing is not that
the former is value-free while the latter is value-laden. Rather it is a contrast between a
particular set of value judgements embodied in the efficiency approach on the one side,
and the more general framework of social analysis which permits systematic
consideration of value judgements, one of which is in fact the particular set embodied in
the efficiency approach. In this perspective the social pricing procedure suggested by SVT is designed to provide less extreme assumptions than those required under the
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efficiency approach. The basic framework for social pricing in the S-VT system assumes
that at the margin all public sector income is invested and all private sector income is
consumed. If the net increase in private sector consumption arising from a particular
project is denoted by C and is the consumption factor that translates the aggregate
consumption basket to border prices, then the amount that accrues to the public sector out
of net benefits is equivalent to (NB' - C). This is also equal to the amount that is
available for public investment. If the goal of the government is to increase growth by
placing a premium on investment, the net social benefit (NSB) may be expressed as
follows:
NSB = (NB' - C) V + C

(4)

Where V is the shadow price of public income/investment at border prices in terms of

private consumption at domestic prices.
To translate the analysis is from a unit of account in terms of private consumption into
the S-VT numeraire, equation (4) may be divided through by V such that:
NSB/V = NSB' = (NB' - C (l 1/V)

(5)

It is clear from the above expression that if public income is at a premium relative to
private consumption (i.e. V > 1), then the NSB' < NB'. The estimation procedure
suggested by S-VT far the derivation of V is based on a comparison of the marginal
productivity of capital to the consumption rate of interest, which is defined as the
discount rate that translates future consumption into present value streams (see Lyn
Squire Land Herman G. van der Tak. (1975). S-T pp. 69).
The above analysis ignored distribution and the fact that Gross National Product growth
was possibly suboptimal. To incorporate these considerations into the analysis, the S-VT
approach assumes that the government values an additional unit of consumption accruing
to the poor as more valuable than the same unit accruing to the rich. This may be
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represented by a system of consumption weights di for the ith income group, where
average income in the country is used as the basis of comparison. The consumption
weights are derived from a CES utility function from which the marginal utility function
at any level of consumption is derived as follows:
Uc = C-n

(6)

Where C is the consumption level and n is the elasticity of marginal utility with respect
to consumption. In this formulation, the higher the level of n, the more "egalitartan" is the
government's objective function, since a higher level of n indicates a higher rate of
diminishing marginal utility. The weights di are derived as follows:
di = Uc/U - (/C)n

(7)

Where is the average level of consumption. It should be noted that for Squire-Tak, the
utility function is equated with the objective function of the government. Consequently,
the distribution weights derived from the utility function would by definition express the
government's preferences for redistribution. (see Lyn Squire Land Herman G. van der
Tak. (1975).S - T pp. 63 - 66).
Incorporating the consumption weights into equation (4), the net social benefit of any
project will be;
NSB' = NB' - Ci (1 di/V)

(8)

Equation 8 sums up the essence of social pricing under the S-VT approach. The first term
of the right-hand-side of the equation (NB') is simply the efficiency price, while the
second term on the same side of the equation C (1 - di) captures the distributional
impact of the project. The latter impact measures the increase in private sector
consumption at the border prices () and the social benefit of additional consumption in
the private sector d/V.
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At a consumption level di/V - l, the distributional impact term disappears and the net
social benefit (NSB') of a project is exactly equal to the net efficiency benefit (NB'). This
is the so called critical consumption level, and it is the level at which the government
judges private sector consumption to be as valuable as public investment.
Another aspect of the critical consumption level is that it serves as a very valuable device
for cross - checking the estimates of what are otherwise very elusive concepts - i.e. the
value of public income V and the consumption distribution weight di. In fact, given the
initial estimates of V and di, policymakers may compute independent estimates of the
critical consumption level by considering recent government policies (subsidies, income
taxes etc.) which may provide the informational input for its estimation.

4. RELATIONSHIPS BETWEEN APPROACHES OF ECONOMIC ANALYSIS

Similarities
There is a considerable similarity between the UNIDO approach and the L-M approach in
the following ways:
1. The mathematical formulation for L-M is identical to the UNIDO method except
for differences in assigning value to discount rates and accounting for
imperfections and other market failures and social considerations.
2. Both methods single out the values of foreign exchange, savings and unskilled
labour, as crucial sources of a distorted price mechanism.
3. Both go on to calculate accounting prices which will correct these distortions and
both carry out these corrections in an essentially similar manner.
4. Both advocate Discounted Cash Flow analysis and the use of Present Social
Values.

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5. Both method works making explicit allowance for inequality and distributional
considerations in project choice through manipulation of the shadow wage.
Differences
The three approaches agree in principle but differ in emphasis and detail (Donahue,
1980). Some key methodological items and points of departure are:
1. Numeraire
L-M nominates their numeraire as Uncommitted Government Income measured in
terms of foreign exchange (Little & Mirrless, 1974). Dasgupta, Sen, and Marglin
propose Aggregate Consumption for the UNIDO approach (Dasgupta, Sen, & Marglin,
1972) while S-VT suggests Uncommitted Public Income measured in terms of
Convertible Currency (Squire & Van der Tak, 1975).
2. Foreign Exchange
The UNIDO methodology uses a shadow exchange rate which functions as a correction
factor and sets the shadow prices of foreign commodities on par with the prices of
comparable domestic goods and services. The L-M system of shadow pricing values
project inputs and outputs at world prices. The S-VT approach also adopts this basic
strategy with only minor adjustments.
3. Investment and Consumption
Generally, for developing countries, CBA should favour projects that route a larger
portion of their benefits into investment rather than consumption (Donahue, 1980). All
the three methodologies provide the mechanics for expressing this priority in quantitative
terms.
4. Discounting
The discount rate is a crucial variable in cost benefit analysis. Dasgupta et al (1972)
UNIDO methodology uses a single rate, the social discount rate, for adjusting future
resource flows. It is fixed by political value judgment of societys time preference, and
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the priority of present versus future consumption (Donahue, 1980). Little and Mirrless
(1974) approach begins with a time preference rate, the consumption rate of interest.
They go on to develop an accounting rate of interest defined as the rate of fall in the value
of their numeraire, uncommitted income. Squire and van der Tak (1975) like LM start
from a time preference rate and then adjust it by the premium on public investment funds
and the marginal productivity of invested resources.
5. Political Context
CBA requires that social values be articulated and then translated into clear, quantified
parameters (Donahue, 1980). LM Approach propose a Top-Down mechanism where
high level officials would specify priorities and commit them to numbers, which it would
then pass to project designers and evaluators (Little and Mirrless 1974). Dasgupta et al
(1972) (UNIDO approach) are skeptical of this strategy and propose a Bottom-Up
mechanism for setting weights. The key to this approach is a special sort of sensitivity
analysis, the testing of several alternative project designs in with different values for the
discount rate, distribution weights and so on. These alternatives would be submitted to
political decision makers who further test and refine them before they are eventually
used. The World Bank Approach uses a Side-to-Side approach to fixing values. The
weights and judgments are worked out collaboratively and reflect the objectives both of
the national government and the lending agency (Squire and van der Tak, 1975).

5. APPLICATIONS OF ECONOMIC APPRAISAL

METHODS IN TANZANIA
The main goal of the three approaches of economic analysis L-M, UNIDO and S-VT
approaches of economic analysis is balancing equity and efficiency objectives from the
point of view of society. Developing countries are characterized by market imperfections,
externalities, taxes and subsidies, concern for savings, concern for redistribution, and
merit wants (Chandra 1995).
1. Market imperfections

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The price system in developing countries especially Tanzania is heavily distorted by

government duties, subsidies, and restrictions, coupled typically with considerable overvaluation of the countries currencies, which forms a poor starting-point for the relative
valuation of project inputs and outputs. From the social point of view, taxes and subsidies
are nothing but transfer payments. But in CBA, taxes and subsidies are treated as
monetary costs and benefits respectively. In addition, Market prices, the basis for cost
benefit analysis (CBA), do not reflect the social values under imperfect market
competition. Financial profitability as calculated in stage one of UNIDO approach would
be sufficient only if the project operated in perfect market. Only in a perfect market,
market prices can reflect the social value. But if the market is imperfect as it in
developing countries like Tanzania, net benefit of the project is determined by assigning
shadow prices to inputs and outputs. Therefore, developing shadow prices is very much
vital as it reflects the real value of resources (input and output) to society.
2. Imperfect labour markets
Structural features of many developing economies such as the dualism between formal
and informal sectors, and the predominance of household enterprises in traditional
agriculture combined with policy distortions have important implications for labour
markets. In developing countries, there is often a high level of urban unemployment, and
also (arguably) of urban underemployment and of surplus labour in agriculture, which
raised complex questions about the effective opportunity-cost of unskilled labour and
hence about the appropriate shadow wage-rate for appraisers to use.
3. Savings and Investment
In SCBA, the division between benefits and consumption is relevant wherein higher
valuation is placed on savings. But in CBA such division is irrelevant. The prevailing
view that the rate of economic growth needed to be increased implies that the existing
rate of investment, and consequently of saving, is sub-optimal and that a policy is needed
to boost savings rates. Considering individually, these peculiarities can push project
choices in opposite directions. A presumed need to increase the savings rate could favour
capital-intensive methods because they would shift income toward corporations and
xvii

richer people higher saving-rates than the average. On the other hand, recognition that
market wage rates in the formal sector exceed the marginal opportunity-cost of labour
dictates greater labour-intensity than markets can signal out, which can shift disposable
income towards the poorer. By providing frameworks for quantifying these
considerations, the L-M and UNIDO approaches enables the poor and the rich to be
balanced against each other.
4. Income distribution
Income in developing countries is unevenly distributed and was and direct redistribution
considered difficult. This could be taken to imply that extra consumption for poorer
people should have a higher priority in the assessment of projects than extra consumption
for richer people. In social cost benefit analysis (SCBA), the distribution of benefits is
very much concerning issue where commercial private firm does not bother about it.
Government considers a project as an investment for the redistribution of income in
favour of economically weakens sections or economically backward regions. This stage
provides a value on the effects of a project on income distribution between rich & poor
and among regions.
5. Externalities
A project may have beneficial or harmful external effects that are considered in SCBA
analysis. An externality is an external effect either beneficial or harmful causes from a
project which is not deliberately created by the project sponsors but is an incidental
outcome beyond the control of the persons who are benefited or affected by it not traded
in the market place. Although valuation of an external effect is difficult as are often
intangible in nature and there is no market price, shadow pricing of externalities may be
made indirect. Example of External Effects:A project of planting trees for commercial
purpose may give protection to the environment against the increasing global warmth.
People may be affected by erosion and flood conditions brought about by changes to the
river which result from the construction activities of a bridge. The harmful effect of
bridge may be measured by the consumer willingness to pay for the output of the people

xviii

which has been reduced due to the bridge. The cost of pollution may be estimated in
terms of loss of earnings as a result of damage to health caused by it.

6. CONCLUSIONS
Economic analysis aids in evaluating individual projects within the planning framework
which spells out national economic objectives and broad allocation of resources to
various sectors. It is also an important tool for analyzing a project to reflect its positive
and negative impact on the society. Today, economic analysis has expanded to evaluation
of private projects as they are much more responsible for good and bad effects on the
society. Economic analysis differs from financial analysis in the sense that it avoids
market price and adopts shadow price to value the inputs and outputs of a project.
UNIDO approach & L-M approach for economic analysis of a project are not widely
used by private sectors. The logic behind the appraisal criterion is to select those projects
for which the countrys resources are more appropriate. Thus, the decisions regarding
capital allocation should be taken with regard to Rule Utilitarian approach i.e.
maximizing benefits to people (various stakeholders) at large as businesses cannot strive
on profit motives for long term. It is high time that businesses should align their strategies
in line with the needs of the community in order to foster long term sustainability of the
business. It should be noted that the choice of the numeraire does not make any real
difference in the analysis from an economic or mathematical viewpoint as long as
consistency is maintained throughout the analysis.
These methods of cost-benefit analysis are broadly similar in principle, in procedure, andmost economists agree in the guidance they are likely to give on accepting, rejecting, or
modifying a project. All seek to establish the net benefit promised by a given project
design. Benefits are defined by reference to development objectives and are balanced
against opportunity costs. Each methodology assumes economic distortions, disequilibria,
and other malfunctions-problems serious enough to warrant the substantial effort that
shadow pricing requires. Equally important is the argument that projects-shaped, when
appropriate, by shadow prices-are more promising instruments for encouraging
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investment or equity than direct fiscal measures. Finally, the methodologies share the
same mechanics of discounting and summarizing, and the power of each is enhanced by
sensitivity analysis.

REFERENCES
Belli Pedro, (2001), Economic Analysis Of Investment Operations: Analytical Tools And
Practical Applications.
Belli Pedro. (1996). Is economic analysis of Project Still Useful? The World Bank
Operations Policy Department. Policy Research Working Paper No. 1689.
Lal, D. (1974). Methods of Project Analysis, (Balt. John Hopkins University Press).
Linn, J. (1977). Economic & Social Analysis of Projects: A case Study of Ivory Coast.
(Wash. D. C. World Bank Staff Working Paper No. 253).
Little. I.M.D., and J.A. Mirrlees. (1974). Project Appraisal and Planning For Developing,
Countries (London: Heineman Educational Books Ltd.).
Lyn Squire Land Herman G. van der Tak. (1975). Economic Analysis of Projects.
Published for the World Bank. The Johns Hopkins University Press, Baltimore and
London

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