2 PRINCIPLES UNDERLYING THE ECONOMIC ANALYSIS OF PROJECTS
Interface of Project with the Markets Factor Markets Project Output Market (Labor & Capital) The role of microeconomics in project evaluation is to determine economic benefits or economic costs, which differ, more often than not, from financial benefits or financial Costs. 3
Introduction to Economic Analysis The financial analysis of a project focuses on its financial attractiveness to its private investors. The economic analysis measures the impact of the project on the entire society. An economic analysis of a project helps determine whether the project increases the net wealth of a countrys society as a whole or not. A project with a negative economic net present value will serve to shrink the economy rather than grow it. For example, if $1,000 investment and NPV equals to $ -270. Then the project uses $1,000 of resources and only produces $730 of value. 4
Estimation of Economic Prices Financial prices are market prices, which are affected by the various tariffs, taxes, and subsidies. Economic values may differ from financial prices because: 1.consumers valuation of an item may be greater than financial price they pay, e.g. road usage, water. 2.financial costs may not be the true costs, e.g. Natural gas is sold to electricity utility in Egypt at a financial price that is only 1/3 of international opportunity cost. Calculating the economic values requires an understanding of how to integrate financial values, tariffs and taxes, handling and transportation costs, and exchange rate distortions. 5
Commodity Specific Conversion Factors (CSCF) Financial prices are market prices, which incorporate all the tariffs, taxes, and subsidies. These market distortions can often be combined and expressed as a proportional distortion D. Where the combined rate of the distortions D is expressed as a proportion of the financial price 6
Commodity Specific Conversion Factors (CSCF) Financial prices are market prices, which incorporate all the tariffs, taxes, and subsidies. We use the conversion factor to convert each of the financial cashflow into the economic cost or benefit in the economic resource statement in the economic appraisal. Suppose, the project is using (purchasing) cotton yarn, the relevant financial price to the project would be the demand price, P d, (the price paid by the project). The financial price to the project is R22,239 and the economic value is R18,794. The economic value is less than financial price because the economic value doesnt include tax. 7
Example of Financial and Economic Cashflows: the Case of Electricity Project Table of Parameters for Economic Analysis Economic Opportunity cost of capital10% Economic Opportunity cost of Labor80%of financial wage bill Foreign Exchange Premium15% Subsidy on Gas30% of Financial Cost Willingness to pay for electricity3.00Rs/Kwh Resource flow: Economic Points of View (millions Rs.) Year CF* 200120022003200420052006 Inflows Sales4500 Land (Subsidy)0.000 Liquidation value of land1.00300 Total Inflows04500 300 Outflows Land1.00300 Long term investment Machinery1.159200 Equipment1.1514840.00 Gas**1.50560.63560.6 Coal1.15258.75258.8 Labor Wages0.8096 Total Outflows10,984915 0 Net Cashflows -109843585 300 NPV @10%566 *CF = Conversion Factors Table of Parameters for Financial Analysis Price of Electricity2.20Rs/KwhLong term investment Production of Electricity1,500Gwh/year Machinery8,000 Equipment1,290 Gas0.25per KwhFinancial Cost Land (Given as subsidy) 300 of Capital12% Coal0.15Rs/Kwh Cashflow: Financial Points of View (millions Rs.) Year200120022003200420052006 Inflows Sales3300 Land (Subsidy)300 Liquidation value of investment0 Liquidation value of land300 Total Inflows3003300 300 Outflows Land300 Long term investment Machinery8000 Equipment1290 Gas375 Coal225 Labor Wages120 Total Outflows9,590720 0 Net Cashflows -92902580 300 NPV @12%-1283 **CF for gas = [(1.3)*(1.15)]/1 = 1.5 8
Three Postulates Underlying the Economic Evaluation Methodology These postulates are based on a number of fundamental concepts of welfare economics. 1)The competitive demand price for an incremental unit of a good or service measures its economic value to the demander and hence its economic benefit. 2)The competitive supply price for an incremental unit of a good or service measures its economic resource cost. 3)Costs and benefits are added up without regard to who the gainers and losers are. 9
The implication of these postulates for the economic analysis of a project First Postulate The competitive demand price (or the consumers willingness to pay) for each additional unit of consumption measures the economic benefit or the economic price of each incremental unit. The demand curve reflects indifference on part of the consumer between having a particular unit of a good at that price and spending the money on other goods and services. Demand A Q0 P 1 = 0.120 C Data Traffic (minutes/ year) Q1Q1 (MWTP) P 0 = 0.280 Tariff /Coping Cost (US$/minute) Economic Value of Local Calls for Rural Customers Economic value = Q 0 ACQ 1 = Willingness to Pay Consumer Surplus (P 1 AC) Payment for services 10
The implication of these postulates for the economic analysis of a project (Contd) Second Postulate The competitive supply price of each incremental unit of a good measures the economic cost of the resources (inputs) that goes into the production of that unit. Suppliers will be indifferent between selling incremental units of the good at their supply prices and using the factors to produce other goods and services. The supply (marginal cost) curve represents the minimum prices that suppliers are willing to accept for successive units of a good or service that they supply. In a competitive market these minimum prices represent the marginal opportunity cost of these goods. Q0 MC Number of rural telephone calls Cost Q1Q2 O Installation (Marginal Cost) of one more terminal and demand for rural telephone calls D1D1 D2D2 11
Third Postulate Costs and benefits are added up without regard to who the gainers and losers are. –Focus on economic efficiency Should the project be valued differently depending on whom are the beneficiaries and the losers? – Not by the economic analysis. This methodology measures the net economic benefit of the project by subtracting the total resource costs used to produce the projects output from the total benefits of the output. This approach attempts to separate the social aspects of project appraisal from the economic efficiency aspects. The implication of these postulates for the economic analysis of a project (Contd) 12
Output from a project affects the market equilibrium. The changes in quantity demanded, quantity supplied and price translate into cost savings due to cuts in production of inefficient producers and an increase in consumption because of lowering of the market price. Measuring Economic Benefits of a Projects Output 13
Economic Benefits of Project Output (No Distortions) Value of Resources Saved Value of Increased Consumption Price S 0 + Project S0S0 D0D0 P0mP0m P1mP1m A C GF E B D Q s1s1 d1d1 Q Q0Q0 QTQT Quantity Economic Value = W x s P s +W x d P d If no output market distortions, then: P s = P d = P m Financial benefit is P 1 m (Q 1 d -Q 1 s ) Economic benefit is Q 1 s GCQ 0 + Q 0 CFQ 1 d 14
A project requires inputs for production. Demand of inputs by the project deprives some consumers in the market because of an increase in the market price. The rise in the market price invites additional investment in input markets, depriving funds for other sectors. These costs together constitute projects gross economic costs. Measuring the Economic Costs of a Projects Inputs 15
Economic Costs of Project Input (No Distortions) Q d 1 Q s 1 S 0 P m 0 A B C Units Rand/Unit Q 0 D 0 D 0+P 0 P m 1 Value of postponed consumption Value of additional resources 16
Small versus Large Changes in Prices Often the quantity produced by a single project or purchased as inputs by a project, is relatively small compared to the size of the market and hence there is little or no change in the market price. In such a situation and given that we are operating in an undistorted market, the gross financial receipts will be equal to the gross economic benefits. The triangle ABC is very small. A difference arises only when the quantity produced by the project or demanded by the project is sufficiently large to have an impact on the prevailing market price in the sector. 17
W x s = Supply Elasticity Supply Elasticity - Demand Elasticity - = W x d = Demand Elasticity - Supply Elasticity - Demand Elasticity - = = (defined positively) own price elasticity of supply = (defined negatively) own price elasticity of demand Weights expressed in terms of elasticities: WxsWxs WxdWxd - = These are long-run elasticities of demand and supply. They are an average elasticity representing for the adjustments made by the market. 18
Calculating the Economic Value of Non-Tradable Goods Economic Value = W x s P s + W x d P d = weighted average of supply (P s ) and demand (P d ) price Where: W s + W d = 1 If rationing then W s = 0 and W d = 1 Traded: Importable W s = 1 and W d = 0 Exportable W s = 0 and W d = 1 Non-tradedW s 0 and W d 0 Three classes of goods:W s W d 2/31/31/2 1/32/3 19
Applying the Postulates to Determine 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. 20
1. Sales Taxes Levied on Output of Project Economic Benefit of an Output Supplied by a Project --- when a tax is imposed on sales --- Financial benefit is P 1 m (Q 1 d -Q 1 s ) Economic benefit is Q 1 s CBB A Q 1 d m P d = P m + T if unit tax P d = P m (1+t) if ad valorem W s P 0 m + W d P 0 m (1+t) Economic Benefits Value of Increased Consumption Value of Resources Saved Example W x s =1/3, W x d =2/3 P m =120, t x =0.15 P e = 1/3(120) + 2/3(120)(1+0.15) = 132 P e = 40 + 80(1.15) = 132 21
2. Subsidies on Production Economic Benefits of a New Project -- when a production subsidy is present -- Financial benefit is P 1 m (Q 1 d -Q 1 s ) Economic benefit is Q 1 s A B Q 0 + Q 0 BCQ 1 d Or if subsidy is proportion of total cost, and Example W x s =1/3, W x d =2/3 P m =120, K=0.40 P e = 1/3(120/(1-0.40)) + 2/3(120) = 146 Value of Resources Saved Value of Increased Consumption 22
3. Sales Taxes Levied on Input of Project Economic Cost of an Input Demanded by a Project --- when a tax is imposed on sales --- Financial cost is P 1 d (Q 1 s -Q 1 d ) Economic cost is Q 1 d C B Q 0 + Q 0 BAQ 1 s Example W x s = 0.25, W x d = 0.75, P 0 m = 90, t = 0.15 P e = 0.25 + 0.75 [90(1+0.15)] = 100 Value of postponed consumption Value of additional resources 23
4. Production Input Subsidized Economic Cost of an Input Demanded by a Project --- when an input subsidy is present --- Price S P E G FJ B D Q d1d1 s1s1 QQ Quantity H A s1s1 m1m1 P= / (1-k)P m0m0 P s0s0 = P P = d1d1 m1m1 P = P m0m0 d0d0 D 0+Project S0S0 0 C I After Subsidy 0 D0D0 Economic Costs WxsWxs + W x d P m x0 P (1-k) Example W x s = 0.25, W x d = 0.75, P m = 90, k = 0.40 P e = 0.25[90/(1-0.4)] + 0.75(90) = 105 Financial Cost is P 1 m (Q 1 d -Q 1 s ) Economic Cost is Q 1 d EFQ 0 + Q 0 GHQ 1 S Value of Postponed Consumption Value of Additional Resources 24
D0D0 Q0Q0 0 E D n+P H PzPz J G Q2dQ2d P0mP0m P 0 s =P 0 m /(1-k z ) S 0+subsidy DnDn Q1sQ1s Q1dQ1d QzQz B C N A P1mP1m S0S0 P 1 s =P 1 m /(1-k z ) P 0 d =P 0 m (1+t z ) P 1 d =P 1 m (1+t z ) M L U R 5. Sales Tax and Production Subsidy on Input Economic cost of a Project -- When a production subsidy and a sales tax are present -- Financial Cost is P 1 m (Q 1 d -Q 1 s ) Economic Cost is Q 1 d MGQ 0 + Q 0 RLQ 1 s Example W x s = 0.25, W x d = 0.75 P 0 m = 90, t = 0.15, k = 0.4 P 1 s = 90/(1-0.4) = 150, P 1 d = 90(1+0.15) =103, P e = 0.25(150) + 0.75(103) = 114 Value of additional resources Value of postponed consumption 25
Price Q0Q0 Quantity P s =P m D 0+P D0D0 Q1Q1 Economic Value of Increase in Quantity Demanded of an Input in the Case of the Infinite Supply Elasticity - Example of Electricity Supply by Thermal Generation - Project demand (Q 1 – Q 0 ) of a non-tradable input W s = 1 and W d = 0 If no direct subsidy then P s = P m 26
6. Environmental Externalities A Project with Pollution in the Lake Financial benefit is P 1 m (Q 1 d -Q 1 s ) Economic benefit is Q 1 s A B BCQ 1 d 27
Relationship between Market Prices and Demand and Supply Prices under Various Types of Distortions 28
29 Applying the Postulates to Determine Economic Evaluation of Tradable Goods and services The framework for the estimation of economic prices was presented for the case of non-tradable goods. They are also applicable to the valuation of tradable goods. These postulates are general in nature and are also applicable to tradable goods. The methodology for the estimation of the economic prices of internationally tradable goods and services when there are distortions in their markets is also based on the three postulates. These distortions may include customs duties on imported inputs of a project or those imported items that the project output will replace or substitute.
30 The Economic Opportunity Cost of Capital One of the practical ways to measure this parameter is to use the economic opportunity cost of funds that are drawn from the capital market. In a small, open and developing economy, there are three alternative sources for these public funds: –The first source comes from those resources that would have been invested in other investment activities that have been either displaced or postponed by our projects extraction of funds from the capital market. –The second source is from individual savers whose resources would have been spent on private consumption due to an increase in domestic savings. –The third source is additional foreign capital inflows.
31 Foreign Exchange Externality The foreign exchange externality is meant to capture any indirect external welfare effects that result from a project's incremental use or production of foreign exchange. The source of this externality lies in the divergence that exists between the marginal value of a unit of foreign exchange and the marginal cost of earning that unit. This divergence is ultimately due to import tariff, export taxes, sales taxes, excise taxes and any other tax or quantitative restrictions distortions in the markets underlying the demand and supply of foreign exchange.
32 The Economic Opportunity Cost of Labor In the labor market there are a variety of factors that may create a divergence between the market wage and the economic cost of a worker at the project. This economic cost of employment reflects both the value of the market and non-market activities undertaken by the worker prior to joining the work force at the project and all other factors that govern the desirability of working at the project. It will also take into account any tax differentials that the worker may face as a result of moving to the project from another employment or unemployment.
Valuation of Non-Market Goods/Services Revealed preference method: using the data obtained by observing the actual choices made by individuals in related markets. State preference method: refer to direct survey approach to estimating the value placed on non-market goods or services. 33