UNIT 8: ECONOMIC ANALYSIS OF A PROJECT

Contents
8.0 Aims and Objectives
8.1 Introduction
8.2 Economic Analysis vs. Financial Analysis
8.3 Approaches to Economic Analysis
8.3.1 UNIDO Approach to Economic Analysis
8.3.2 Little-Mirrlees Approach to Economic Analysis
8.4. Summary

8.1 INTRODUCTION

The economic analysis, also called social cost-benefit analysis (SCBA), is a methodology
developed for evaluating investment projects from the point of view of the society or
economy as a whole. Although economic analysis can be applied to both profit oriented
(private) projects and public investments, it is primarily used for evaluating public
investments.

Since private investments get approval from the government and quasi-governmental
agencies, economic analysis is applied to private investments. Economic analysis helps in
evaluating individual projects within the planning framework, which indicates national
economic objectives and broad allocation of resources to various sectors. In other words,
economic analysis is concerned with tactical decision-making within the framework of broad
strategic choices defined by planning at the macro level. The perspectives and parameters
provided by the macro level plans serve as the basis of economic analysis. These perspectives
and parameters are considered as tools for analyzing and appraising individual projects.

8.2 ECONOMIC ANALYSIS VS FINANCIAL ANALYSIS

Financial analysis focuses on monetary costs and benefits of the project whereas economic
analysis focuses on the social costs and benefits of the project. What are the principal sources
of discrepancies between financial analysis and economic analysis? The major sources of
discrepancies are:

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1. Market imperfections
In computing the monetary costs and benefits, market prices are the base. Market prices show
social values only under conditions of perfect competition. However, in developing countries,
markets are not perfect and as a result imperfections occur. When imperfections exist, market
prices do not show social values. The common market imperfections are:
a) Rationing – The control of the prices and distribution of commodities. The price paid
by the consumer is less than the market price that would prevail in a
competitive market.
b) Prescription of minimum wage rates
c) Foreign exchange regulation – the official exchange rate is less than the rate that
would prevail in the absence of foreign regulations.

2. Externalities
Externalities refer to the external benefits or costs that the project creates and for which the
users do not pay or get compensation. For example, a project may create infrastructure
facilities like roads. These roads benefit the neighboring areas. Financial analysis ignores such
benefits in assessing the project because the owners of the project do not receive any
monetary compensation from those who enjoy this external benefits created by the project.
Similarly, a project may have a harmful effect such as pollution of the environment. Financial
analysis does not take into account such harmful effect of the project. However, in economic
analysis, all costs and benefits of the project are relevant irrespective of whom they accrue
and whether they are paid for or not.

3. Taxes and Subsidies

From financial analysis point of view, taxes are definite monetary costs and subsidies are
definite monetary gains. An example of subsidy is tax exemption (holiday) granted by the
government. From the social point of view, taxes and subsidies are generally regarded as
transfer payments. Thus, taxes and subsidies are irrelevant for economic analysis.

4. Concern for savings

In evaluation of private investments, the division of benefits between consumption and
savings is not made. In other words, private investments do not put differential valuation on

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savings and consumption. From social point of view, it is relevant to divide the benefits
between consumption and savings. It is generally believed that a Birr benefit saved is deemed
to have more value than a Birr benefit saved. This means a higher valuation is placed on
savings and a lower valuation is put on consumption. Thus, economic analysis of the project
reflects the concern of the society for savings as well as investments.

5. Concern for Redistribution

Different groups in the society get benefits from the project. A private firm does not bother
how its benefits are distributed across various groups. However, the society is concerned
about the distribution of benefits across different groups. This is based on the assumption that
a Birr of benefit going to an economically poor section is considered more valuable than a
Birr of benefit going to an affluent (rich) section of the society. Thus, economic analysis of
the project is concerned with the redistribution of the benefits from the project.

6. Merit wants
Merit wants refer to goals and preferences that are not expressed in the market place. These
goals and preferences are believed by policymakers to be in the larger interest. For example,
the government may prefer to promote girls education. This is not sought by consumers in the
market place. Merit wants are not relevant from the private point of view. But they are
important from the social point of view.

8.3 APPROACHES TO ECONOMIC ANALYSIS

There are two approaches to economic analysis. These are:

1. UNIDO Approach
2. Little-Mirrlees (L–M) Approach

8.3.1 UNIDO Approach

The United Nations Industrial Development Organization (UNIDO) method of the project
appraisal involves five stages. These are:
1. Calculation of the financial feasibility of the project measured at market prices
(Financial Analysis of the Project).
2. Obtaining the net benefits of the project in terms of economic (efficiency) prices.

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 3. Adjustment for the impact of the project on savings and investments.
4. Adjustment for the impact of the project on income redistribution.
5. Adjustment for the impact of the project on merit goods and demerit goods whose
social values differ from their economic values.

Each stage of project appraisal measures the desirability of the project from a different angle.
Except the first stage, which is an independent title, the remaining are described in the section
that follows:

8.3.1.1 Net Benefit in terms of Economic (Efficiency) Prices

The second stage of UNIDO approach is concerned with the determination of the net benefits
of the project in terms of economic, efficiency, or shadow prices. In perfect markets, market
prices represent shadow prices. But when there is market imperfection, market prices do not
represent shadow prices and hence there is a need to develop shadow prices that is used to
determine net economic benefits of the project.

Before dealing with shadow pricing of specific resources, it is desirable to discuss the basic
concepts and issues. Some of the basic issues include:

a) Choice of Numeraire
Numeraire refers to the unit of account in which the value of inputs or outputs is expressed.
To define numeraire, the following questions have to be answered.
- what unit of currency (domestic or foreign) should be used to express benefits and
costs?
- should costs and benefits be measured in current values or constant values?
- with references to which point (present or future) should costs and benefits be
evaluated?
- what use (consumption or investment) will be made of the income from the project?
- should income of the project be measured in terms of consumption or investment?
- with reference to which group should the income of the project be measured?

The specification of the UNIDO Numeraire in terms of the above questions is: “Net present
consumption in the hands of people at the base level of consumption in the private sector in
terms of constant price in domestic accounting Birr.”

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b) Concepts of Tradability
Whether a good is tradable or not is the key issue in shadow pricing. The international price is
a measure of its opportunity cost to the country for tradable goods. For tradable goods, it is
possible to substitute import for domestic production and vice versa. Likewise, it is possible
to substitute export for domestic consumption and vice versa. Thus, the international price
(also called the border price) represents the real value of the goods in terms of economic
efficiency.

c) Sources of shadow prices

A project uses and produces resources. A project may for any given input or output:
i. Increase or decrease the total consumption in the economy
ii. Increase or decrease production in the economy
iii. Increase or decrease imports, or
iv. Increase or decrease exports
According to UNIDO, there are three sources of shadowing pricing; namely,
1. Consumer willingness to pay – used if the impact of the project is on consumption in
the economy
2. Cost of production – used if the impact of the project is on production in the economy.
3. Foreign exchange value – used if the impact of the project is on international trade.
How project affects international trade? The project may increase/decrease imports or
exports.

d) Taxes
When shadow prices are being calculated, taxes usually pose difficulties. With respect to
taxes, UNIDO’s guidelines are as follows:
1. Include taxes in shadow pricing – when a project results in diversion of non-traded
inputs, which are in fixed, supply from other producers or addition to non-traded
consumer goods.
2. Exclude taxes from shadow pricing – when a project augments domestic production by
other producers. Taxes should also be excluded from shadow pricing for fully traded
goods.

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Shadow Pricing of Specific Resources
1. Shadow pricing for tradable inputs and outputs
A good is fully traded when an increase in its consumption results in a corresponding increase
in import or decrease in export or when an increase production results in a corresponding
increase in export or decrease in import. For such goods, shadow pricing is the border
(international) price translated into domestic currency at the market exchange rate.

For fully traded goods, domestic changes in demand or supply affect just the level of imports
or exports. The following conditions should be met for imported goods to be traded.
a) If there is an import quota, goods are not restrictive
b) The import supply is perfectly elastic over the relevant range of import volume
c) There is no surplus domestic capacity, it cannot be utilized for want of necessary
inputs.
d) If the additional demand exists in land, the imported goods cost less than the marginal
cost of production.
e) The imported input costs less than the domestic marginal cost of purchase.

When the above conditions are met, additional demands are satisfied by external trade.
Similar conditions must be satisfied for importable outputs, exportable inputs, and exportable
outputs. If a good is not tradable if it is tradable but does not fulfill conditions (a) though (d).

2. Shadow pricing for non-tradable inputs and outputs

For non-tradable goods, the border price does not reflect its economic value. More
specifically, a good is said to be non tradable when the following conditions are satisfied:
a) Its import price (cost-Insurance-Freight) is greater than its domestic cost of
production.
b) Its export price (Free-on-board price) is less than its domestic cost of production.
What then is the value of non-tradable goods?

i. On the output side

If the impact of the project is to increase the consumption of the product in the economy, the
measure of value is the marginal consumers’ willingness to pay. On the other hand, if the

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impact of the project is to substitute other production of the same non-tradable in the
economy, the measure of value is the saving in cost of production.

ii. On the input side

If the impact of the project is to reduce the availability of inputs to other users, their
willingness to pay for that input represents social value. If the projects input requirement is
met by additional production of it, the production cost of it is the measure of social value.

3. Shadow pricing for externalities

Externalities are special classes of goods. Externalities have the following characteristics:
i. They are not deliberately created by the project owners but are incidental outcome of the
economic activity.
ii. They are beyond the control of the persons who are affected by them, for better or for
worse.
iii. They are not traded in the market and thus have no market price. Externalities may be
beneficial or harmful. They are intangible in nature.

So how should the value of externalities be determined?

The values of externalities are estimated by indirect means. For example,
a. Assume that the company designed a training project that helps upgrade the skills of its
workers thereby enhancing their earning power in subsequent employments. From this
description of the project, the beneficial external effect is the enhancement of employees
earning power in subsequency employment. What is the value of this benefit? The benefit
from the training programme may be estimated in terms of increased earning power of
workers.
b. Assume that a highway company is considering the construction of highway that cuts the
holding of a farmer in two, separating his grazing land and his cowsheds, thereby adversely
affecting his physical output. Does the project have beneficial external effect or harmful
external effect on the farmer? Since the project affects the farmer adversely, it will have
harmful external effect. What should be the value of this effect? The value of harmful
external effect of the highway may be measured by the consumer willingness to pay for the
output of the farmer, which has been reduced due to the highway.

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Generally, it is not easier to measure external effects (or externalities). Due to this, some argue
that these external effects should be ignored. Other suggested that external effects should be
taken into consideration whenever it is possible to do so. Although these effects cannot be
measured in monetary terms, some qualitative evaluation must be attempted.

4. Shadow pricing for labour inputs

Labour is considered to be a service. The principles of shadow pricing for goods may be
applied to labor as well.

When a project lives a labour, it could have three possible impacts on the rest of the economy.
i. It may take labour away from other employment
ii. It may induce the production of new workers
iii. It may involve import of workers

When a project takes labor away from other, the shadow price of labour is equal to what other
users of labor are willing to pay for this labor. This will be equal to the marginal product of
such labor in a relatively free market.

The social cost associated with inducing ‘additional’ production of workers consists of the
following:
a) the marginal product of the worker in the previous employment. For unemployed
worker, marginal product is equal to zero.
b) The value assigned by the worker on the leisure that he may have to forgo as a result of
employment in the project. The value of this leisure is reflected in his reservation wage
which depends on:
- the income she/he already enjoys through transfer payments
- his/her idea of what job is acceptable to him.
- His/her preference for work and leisure.
c) The additional consumption of food when a worker is fully employed as opposed to
when he/she is idle or only partly employed.
d) The cost of transport and rehabilitation when a worker is moved from one location to
another.

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 e) The increased consumption by the worker and its negative impact on savings and
investments.
f) The cost of training a worker to upgrade his/her skills.

The social cost associated with the import of foreign workers is the wage they command.

5. Shadow pricing for capital inputs

Capital inputs refer to investments in machinery, building, and other similar physical assets.
Two things happen when a capital investment is made in a project. There are:

a) Financial resources are converted into physical assets

What is the value of physical assets? The value (shadow price) of physical assets is calculated
the way the value of other resources is calculated. If it is a fully traded good, its shadow price
is equal to its international price. The cost of production or consumer willingness to pay
becomes the basis of shadow price for non-traded goods.

b) Financial resources are withdrawn from the national pool of savings and hence alternative
investments are foregone
These financial resources involve opportunity cost. The opportunity cost of capital depends on
how the capital required for the project is generated. To the extent that it comes from
additional savings, its opportunity cost is measured by the consumption rate of interest. The
consumption rate of interest reflects the price the saver must be paid to sacrifice present
consumption. To the extent that it comes from the denial of capital to alternative projects, its
opportunity cost is the rate of return that would be earned from those alternative projects (also
called the investment rate of interest).

6. Shadow pricing for foreign exchange

According to UNIDO, the Numeraire is the domestic currency (Birr). Thus, the foreign
exchange input of the project must be identified and adjusted by an appropriate premium. The
valuation of inputs and outputs that was measured in international price (Birr) has to be
adjusted upward to reflect the shadow price of foreign exchange.

The shadow price of foreign exchange is determined on the basis of marginal social value.
The marginal social value is revealed by the consumer willingness to pay for the goods that

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are allowed to be imported at the margin. The shadow price (value of unit of foreign exchange
is equal to:
n

F
i 1
i Qi Pi

where:
Fi = Fraction of foreign exchange, at the margin, spent on importing commodity i.
Qi = Quantity of commodity i that can be bought with one unit of foreign exchange
1
Qi =
CIF
CIF = Cost, Insurance, Freight
Pi = Domestic market clearing price of commodity i.
To illustrate, the computation of the value of a unit of foreign exchange, assume that
commodity 1, commodity 2 and commodity 3 are imported at margin. The proportion of
foreign exchange spent on them, the quantities that can be bought per unit of foreign
exchange, and the domestic market clearing prices are as follows:
F1 = 0.4 F2 = 0.3 F3 = 0.3
Q1 = 0.8 Q2 = 1.2 Q3 = 4
P1 = 20 P2 = 10 P3 = 15
The value of a unit of foreign exchange is computed as follows:
Value = (0.40 x 0.8 x 20) + (0.3 x 1.2 x 10) + (0.3 x 4 x 15) = Br. 28
The above computation of shadow price is in terms of consumer willingness to pay and is
based on the assumption that the foreign exchange requirements of the project are met from
the sacrifice of others. However, the use of foreign exchange by a project may also induce the
production of foreign exchange through additional exports or import substitution.

In such a case, the shadow price of foreign exchange would be based on the cost of producing
foreign exchange and not consumer willingness to pay for foreign exchange.

To exemplify the computation of net economic benefit, assume that presently a ferry service
(operated privately) is being used to cross a river of Gannale. The ferry operator charges Br. 4
per person. It costs the ferry operator Br. 3 per person. Assume further that about 60,000
persons use the ferry service throughout the year.

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The Bale zone of Oromia Regional state is considering the construction of a bride over the
river. It is estimated that after the bridge is constructed, about 400,000 persons will cross the
river on the bridge. The bridge is expected to cost Br. 2.5 million initially and Br. 20,000
annual maintenance costs. After the bridge is in operation, the ferry operator will close down
the ferry service and the boats will be sold for Br. 150,000. The bridge is expected to have an
indefinite life and the monetary figures indicated in the problem represent economic value.
There is no payment for the use of bridge. The social costs and benefits of constructing the
bridge are summarized below:

Costs
1. A one shot construction cost of Br. 2,500,.000
2. Annual maintenance cost of Br. 20,000
Benefits
1. A one-shot benefit of Br. 150,000 from the sale of
boats
2. The annual benefit in the form of saving in the
cost of ferry operation of Br. 180,000 (i.e., Br.
3/person x 60,000 persons)
3. Increase in consumer satisfaction that is equal to
willingness to pay of 340,000 additional persons
(400,000 – 60,000) who are expected to use the
bridge. The average willingness to pay of
4 0
additional person is Br. 2 (i.e. 2 = 2).

Assuming that demand schedule is linear. The

willingness to pay of 340,000 additional persons
is Br. 680,000 (i.e., 340,000 persons x 2)

Additional examples
1. Suppose the project requires indigenous power equipment costing Br. 900,000
(estimated by project promoter). The power equipment produced indigenously is a
tradable item whose FOB value is $100,000. The shadow price per dollar is Br. 9.5,
though the official price is Br. 8.925. What is the cost of power equipment from:
a) the private point of view.
b) the economic point of view.

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Solution
a) From private point of view, the cost of power equipment is Br. 900,000.
b) The indigenous power equipment is a tradable item for which international price
should be used. The FOB value of this equipment is converted to the birr by applying
the shadow price of foreign exchange to obtain the cost from the economic point of
view. i.e., the cost of the power equipment is Br. 950,000 (9.5 x $100,000)
2. Assume that the project requires power equipment that will be imported at a cost of
$150,000. The equipment will be financed by a gift of $150,000 from a foreign donor.
However, the gift of $150,000 is not related to the project. The shadow price of a dollar
is Br. 9.520, though the official price is Br. 9.00. What is the cost of imported power
equipment from:
a) Private point of view?
b) Economic point of view?
Solution
a) From private point of view, the imported power equipment is not considered project
resources. Thus, no cost is considered.
b) From economic point of view, the cost of power equipment is Br. 1,428,000 (i.e,
$150,000 x 9.520).
3. Assume the construction of a road requires 300,000 tons of cement produced by Muger
Cement factory. The production cost per ton is Br. 60. Assume further that cement is not
tradable and 2/3 of the cement required for the project will come from additional
domestic production which has a cost of Br. 60 per ton and the remaining will come
from diversion from other consumers who are willing to pay, on average, Br. 80 per ton.
What is the cost of cement from:
a) Private point of view?
b) Economic point of view?

Solution
a. From private point of view
Cost of cement = Br. 60 x 300,000 tons = Br. 1,800,000
b. From Economic point of view

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Cement is non-tradable. The quantity of additional production is 200,000 tons (i.e.2/3 x
300,000 = 200,000 tons). The cost of additional production will be Br. 12,000,000 (i.e.
200,000 tons x Br. 60/ton = 12,000,000). Besides, quantities of cement that will come through
diversion are 100,000 tons and the cost of these will be Br. 8,000,000 (i.e., Br. 80 x 100,000
tons = 8,000,000). Thus, the total costs of cement from economic point of view are Br.
20,000,000 (i.e., 12,000,000 + 8,000,000 = 20,000,000).

4. Assume that the project requires 10,000 unskilled labours for which the project control
board (project promoter) has decided to pay a Br. 10 daily wage rate. The shadow price
of unskilled labour is Br. 6 per day. What is the cost of unskilled labour from:
a) Private point of view?
b) Economic point of view?
Solution
a) From private point of view
Cost of unskilled labour = 10,000 x Br. 10 per day = Br. 100,000
b) From economic point of view
Cost of unskilled labour = 10,000 x Br. 6 per day = Br. 60,000

5. Assume that project that involves the protection of food is expected to have annual
saving of Br. 800,000 due to flood damages. What is the benefit of this project from:
a) Private point of view
b) Economic point of view
Solution
a) From private point of view
Financial analysis does not consider such benefit of the project because it does not accrue
to the firm in the form of cash flow.

b) From economic point of view

The value of savings due to flood relief is Br. 800,000.

6. Suppose that a private agricultural firm is considering the construction of irrigation on

Awash River. The irrigation will be used by the farmers for which they will pay to the
agricultural firm per acre. The firm decided that the water charge would be Br. 20 per

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 acre per season. It is estimated that 500,000 acres of land will be irrigated per season.
However, the value of additional output per acre, attributable to the water supplied by
the irrigation project, will be Br. 30 per season. A year has got three seasons. What is the
yearly benefit from irrigation project from:
a) Private firm point of view?
b) Economic point of view?
Solution
a) From private point of view
Benefit = charge per acre x Irrigated land per season x No of seasons
= Br. 20 x 500,000 acres x 3 seasons
= Br. 30,000,000

b) From economic point of view

The value of additional agricultural output attributable to the water supplied by the project
is considered. Accordingly, the economic benefit is computed as follows:
Benefit = Irrigated land per season X value of additional output per acre X number of seasons
= 500,000 acres X Br. 30 X 3 = Br. 45,000,000

8.3.1.2 Measurement of the Impact of Distribution

This is concerned with measuring the value of the project in terms of its contribution to
income redistribution among various groups. For the purpose of income distribution analysis,
the society may be divided into various groups, such as project, government, workers,
consumers, external sector, and other private business.

Within the society, the project results in a gain or loss to an individual group. The gain or loss
is computed in terms of whether the input/output is physical resources and financial
transactions.

Gain or loss to an individual group on physical resources is the difference between the
shadow price and the market price of each input or output. For financial transactions, gain or
loss is the difference between the price paid and the value received. To illustrate the
computation of gain or loss, assume that Residents of certain area use 600,000 cubic meter
water provided by water project. The benefit derived by the residents, measured in terms of

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the willingness to pay, is equal to Br. 20 per cubic meter. The tariff paid by the residents to the
water authority is Br. 15 per cubic meter. What is the gain or loss by the residents due to the
project?
Gain = (20 – 15) x 600,000 = Br. 3,000,000
The shadow price is Br. 20 and the market price is Br. 15. Since the residents are required to
pay less than the shadow price, thus gain from the project.

8.3.1.3 The saving impact of the project

The scarcity of capital characterizes most of the developing countries which are concerned
with the impact of a project on savings and its value thereof. The following questions should
be answered?
- What is the impact of the project, given the income distribution impact?
- What is the value of such saving to the society?
The saving impact of the project is determined as follows:
Saving =  y i MPS i

where:
y i = Chang in income of group i as a result of the project

MPSi = Marginal propensity to save of group i.

To illustrate the computation of saving impact of the project, assume that the income gained
or lost by three groups of the society as a result of the project is shown below:
Group 1 = Br. 600,000, Group 2 = Br. (200,000), Group 3 = Br. 400,000
The marginal propensity to save (MPS) of the three groups is as follows =
MPS1 = 0.20 MPS2 = 0.15 MPS = 0.30
What is the impact of the project on saving?
The saving impact of the project is determined as follows:
Saving = (600,000 x 0.20) + (-200,000 x 0.15) + (400,000 x 0.30)
= 120,000 – 30,000 + 120,000
= 210,000

8.3.1.4 Adjustment for Merit and Demerit Goods

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What are merit goods? Demerit goods? A merit good is one for which the social value exceeds
the economic value. The best example of merit good could be oil, and creation of
employment. A higher social value may be placed over economic value on production of oil
by the country because it reduces dependence on foreign suppliers.

Demerit good is a good whose economic value exceeds social value. Some of the best
examples of demerit goods are tobacco products, and alcoholic products

In order to adjust for merit or demerit goods, the following steps may be used:
1. Estimate the economic value of the project
2. Calculate the adjustment factor
Social value
Adjustment factor = Economic value  1

For merit goods, the ratio of social value to economic value is greater than 1 and adjustment
factor becomes positive. On the other hand, the ratio of social value to economic value is less
than 1 for demerit goods and the adjustment factor becomes negative.

3. Multiply the economic value by the adjustment factor to obtain adjustment

Adjustment = Economic value x adjustment factor
4. Compute the social value by adding adjustment to the economic value
Social value = Economic value  Adjustment
To illustrate the adjustment for the difference between social value and economic value of the
project, assume that the present economic value of the project is Br. 5,000,000. The output of
the project is merit good and its social value exceeds its economic value by 30%.

Based on the above information, the adjustment factor is computed as follows:

130%
Adjustment factor = 1
100%
= 1.30 - 1
= 30%
30%
Adjustment for merit good is computed as follows:
Adjustment = Economic value X adjustment factor
= 5,000,000 X 0.30
= 1,500,000

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Then social value is equal to the sum of economic value and adjustment
Social value = 5,000,000 + 1,500,000 = 6,500,000

8.3.2 Little-Mirrlees (L – M) Approach

I.M.D. Little and J.A Mirrlees have developed an approach to social cost benefit analysis of
the project. The UNIDO and L-M approaches have considerable similarities between them.
Some of the similarities are:
1. The calculation of shadow (Accounting) prices
2. The consideration the factor of equity
3. the use of Discounted Cash Flow (DCF) analysis
Although L-M approach and UNIDO approach are similar in some aspects, they are not
without differences.

There differences are:

UNIDO Approach L-M approach
1. Measures costs and benefits in terms of 1. Measures costs and benefits in terms of
domestic Birr international (border) prices
2. Measures costs and benefits in terms of 2. Measures costs and benefits in terms of
consumption uncommitted social income.
3. The analysis focuses on, efficiency, savings, 3. Tends to view efficiency, savings, and
and redistribution considerations in different redistribution considerations together.
stages

8.3.2.1 Shadow Pricing under L-M Approach

L-M approach classified the inputs and outputs of the project into three categories. These are

a. Tradable goods and services

The border price is considered the shadow price for a traded good or service. Assume that
foreign demand and supply are perfectly elastic, the shadow price of exportable goods is Free-
on-Board (FOB) price. On the other hand, the shadow price of importable good is its Cost
Insurance Freight (CIF) price.

b. Non-tradable goods and services

Certain goods are not amenable to foreign trade, such as land, building, electricity, water, and
transportation. Since there is no observable border price for such goods and services, their

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shadow (accounting) prices are defined in terms of marginal social cost and marginal social
benefits.

The marginal social cost of a good is the value in terms of accounting prices of the resources
required to produce an extra unit of the good. Similarly, the marginal social benefit is the
value of an extra unit of the good from the social point of view.

c. Labour
According to L-M, the shadow wage rate is the function of several factors, some of which
include:
- the marginal productivity of labour
- the cost associated with urbanization such as cost of transport, urban overheads etc.
- the cost of having an additional amount committed to consumption (when the
consumption of the worker increases as a result of the higher income he/she enjoys in
urban employment).

8.4. SUMMARY

Economic (social cost benefit) analysis is a methodology for evaluating projects from the
social point of view. Economic analysis aids in evaluating individual projects with in the
planning framework. In economic analysis, the focus is on social costs and benefits of a
project which tends to differ from financial analysis. The principal reasons for discrepancy are
market imperfections, externalities, taxes, concern for saving and income redistribution, and
merit and demerit goods.

There are two principal approaches for economic analysis of projects; namely, UNIDO
approach and Little-Mirrlees (L-M) Approach. The UNIDO approach involves five stages
(1) Calculation of the financial profitability measured at market prices. (2) Obtain the net
benefit of the project measured in terms of shadow prices (3) Adjustment for the impact of
savings and investment (4) Adjustment for the impact of the project on merit and demerit
goods.

A key issue shadow pricing is whether a good is tradable or not. For a traded good, the
shadow price is the border price, translated in domestic currency at market exchange rate. The

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shadow price of a non traded good is measured in terms of consumer willingness to pay, or
cost of production depending on the impact of the project on the rest of the economy.

Since economic analysis seeks to consider all costs and benefits to whomsoever they may
accrue, external effects (harmful or beneficial) also need to be considered. The valuation of
these external effects is rather difficult because they are often intangible in nature and there is
no market and there is no market price, which can be used as a starting point.

The principles of shadow pricing for goods may be applied to labour as well although labour
is considered a service. When the project takes labour away from other employments, the
shadow price of labour is equal to what other users of labour are willing to pay. The shadow
price associated with inducing “additional” production of workers consists of the marginal
product of labour in previous employment plus certain other costs.

The opportunity cost of capital goods depends on how the capital required for the project is
generated. To the extent that the capital comes from additional savings, its opportunity cost is
measured by the consumption rate of interest. To the extent that it comes from the denial of
capital to alternative projects, its opportunity cost is the rate of return that would be earned
from those alternative projects.

The UNIDO approach uses domestic currency as the Numeraire. The foreign exchange impact
of the project must be identified and valued. The UNIDO approach determines the shadow
price of foreign exchange on the basis of marginal social value as revealed by the consumer
willingness to pay for the goods that are allowed to be imported at the margin.

On the other hand, the L-M approach has considerable similarity with the UNIDO approach
through there are certain important differences. According to L-M approach, the inputs and
outputs of a project are classified into tradable goods and services, non-tradable goods and
services, and labour. The shadow price of a traded good is simply its border price. If a good is
imported, its shadow price is its CIF price. The shadow prices of a non traded goods are
defined in terms of marginal social cost and marginal social benefit.

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