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OUTLINE
Rationale for SCBA UNIDO approach Net benefit in terms of economic (efficiency) prices
Little-Mirrlees approach
Shadow prices SCBA by financial institutions Public sector investment decisions in India
UNIDO Approach
The UNIDO method of project appraisal involves five stages: 1. Calculation of the financial profitability of the project measured at market prices.
2. Obtaining the net benefit of the project measured in terms of economic (efficiency) prices.
3. Adjustment for the impact of the project on savings and investment
(Efficiency) Prices
Shadow Pricing : Basic Issues
Choice of numeraire Concept of tradability Concept of shadow prices Taxes Consumer willingness to pay
Illustration
Presently, a ferry service, operated privately, is being used to cross a river. The ferry operator charges Rs.3 per person. It costs him Rs.2 per person. 50,000 persons use the ferry service. (This means that the number of persons crossing the river by ferry service throughout the year is 50,000) The government is considering construction of a bridge over the river. It is estimated that after the bridge is constructed 2,50,000 persons will cross the river on the bridge. The bridge is expected to cost Rs 3 million initially and its annual maintenance cost would be Rs 10,000. It has an indefinitely long life. Once the bridge is constructed the ferry operator is expected to close down the ferry service and sell the ferry boats for Rs.100,00.
Required : Define the social costs and benefits of constructing the bridge, assuming that the monetary figures given in the problem represent economic values.
Solution : The social costs and benefits of bridge construction may be defined as follows: Costs These consists of the following: 1. Construction cost : Rs.3,000,000 (This is a one-shot cost) 2. Maintenance cost : Rs. 10,000 (This is an annual cost) Benefits These consist of the following : 1. Value of ferries released : Rs 100,000 ( This is one-shot benefit) 2. Savings in the cost of ferry operation: Rs 100,000 (This is an annual benefit) 3. Increase in consumer satisfaction: This is equal to willingness to pay of 200,000 additional persons who are expected to use the bridge. Since the first additional person is willing to pay almost Rs 3 (the charge of the ferry operator) and the late person is willing to pay almost nothing (there is no toll for using the bridge) the average willingness to pay of additional users, assuming that the demand schedule is linear, is Rs. 1.50. So the willingness to pay of 200,000 additional persons is is 200,000 x Rs 1.50 = 300,000.
Government
Workers Consumers External sector
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The gain or loss to an individual group within the society as a result of the project is equal to the difference between the shadow price and the market price of each input or output in the case of physical resources or the difference between the price paid and the value received in the case of financial transactions.
Impact on Savings
The savings impact of a project is equal to: i MPSi Where i = change in income of group i as a result of the project MPSi = marginal propensity to save of group i Example As a result of a project the income gained /lost by four groups is : Group 1 = Rs. 100,000 Group 2 = Rs 500,000, Group 3 = Rs.200,000 and Group 4 = -Rs 400,000. The marginal propensity to save of these four groups is as follows: MPS1 = 0.05, MPS2 = 0.10, MPS3 = 0.20, and MPS4 = 0.40
Value of Savings
I =
r(1-a)
(!+k)
r(1-a)(1+ar)
(1+k)2
+.
r(1-a)
(1+k)
= (1+ar) =
r(1-a)
(k-ar)
1-
(1+k)
wi
ci
Where wi = weight attached to income at ci level b = base level of income that has a weight of 1
Little-Mirrlees Approach
There is considerable similarity between the UNIDO approach and the L-M approach. Both the approaches call for: 1. Calculating accounting (shadow) prices particularly for foreign exchange savings and unskilled labour. 2. Considering the factor of equity 3. Use of DCF analysis Despite considerable similarities there are certain differences between the two approaches: 1. The UNIDO approach measures costs and benefits in terms of domestic rupees whereas the L-M approach measures costs and benefits in terms of international prices, also referred to as border prices. 2. The UNIDO approach measures costs and benefits in terms of consumption whereas the L-M approach measures costs and benefits in terms of uncommitted social income. 3. The stage-by-stage analysis recommended by the UNIDO approach focuses on efficiency, savings, and redistribution considerations in different stages. The L-M approach, however, tends to view these considerations together.
Shadow Prices
The outputs and inputs of a project are classified into the following categories: traded goods and services, non-traded goods and services, and labour. The shadow price of a traded good is simply its border price The shadow (or accounting) price of a non-traded item is defined in
The future social profit for all projects must be discounted in the same way The accounting rate(s) of interest should be such that all mutually compatible projects with positive present social value can be undertaken. The accounting rate of interest should maintain some kind of balance between investment and investible resources: too low an accounting rate of interest would lead to over-investment with inflationary effects and too high an accounting rate of interest would leave savings under-utilised and result in excessive unemployment.
5. The PAD of the Planning Commission carries out a detailed appraisal. The objective of its appraisal is not only to suggest whether to accept or reject the project but also to suggest how it may be re-formulated to enhance its technical, financial, commercial, and economic viability. 6. The Investment Planning Committee of the Planning Commission discusses the appraisal note of the PAD and recommends to the PIB the view of the Planning Commission on whether the project should be accepted, rejected, deferred, reformulated, or redesigned. 7. The PIB considers the (a) appraisal note of the PAD along with the view of the planning Commission, (b) the comments of the BPE, (c) the comments of the plan finance division of the ministry of finance, and (d) the note of the administrative ministry. If the PIB clears the project, it sends it to the cabinet for its approval 8. The cabinet generally accepts the recommendation of the PIB and approves its implementation.
SUMMARY
In SCBA the focus is on social costs and benefits of a project. These often tend to differ from the costs incurred in monetary terms and benefits earned in monetary terms by the project. The principal reasons for discrepancy are: (i) market imperfections, (ii) externalities, (iii) taxes, (iv) concern for savings, (v) concern for redistribution, and (iv) merit and demerit goods Towards the end of the sixties and early seventies two principal approaches for SCBA emerged : UNIDO approach and Little- Mirrlees approach. The UNIDO method of project appraisal involves five stages: (i) calculation of the financial profitability of the project measured at market prices; (ii) obtaining the net benefit of the project measured in terms of economic (efficiency) prices; (iii) adjustment for the impact of the project on savings and investment; (iv) adjustment for the impact of the project on income redistribution; and (v) adjustment for the impact of the project on merit and demerit goods. As per the L-M approach, the outputs and inputs of a project are classified into the following categories: (i) traded goods and services, (ii) non-traded goods and services, and (iii) labour.
The shadow price of a traded good is simply its border price. If a good is exported its shadow price is its FOB price and if a good is imported its shadow price is its CIF price. The shadow prices for non-traded items are defined in terms of marginal social cost and marginal social benefit. The L-M approach suggests the following formula for calculating the shadow wage rate (SWR) SWR = c 1/s (c-m)
While the all-India term-lending institutions IDBI, IFCI, and ICICI- approach project proposals primarily from the financial point of view, they also evaluate them from the larger social point of view.
Though there are some minor variations, the three institutions follow essentially a similar approach which is a simplified version of the L-M approach. IDBI, the apex term-lending financial institutions, considers three aspects in its economic appraisal of industrial projects: economic rate of return, effective rate of protection, and domestic resource cost The economic rate of return is simply the internal rate of return of the stream of social costs and benefits. The effective rate of protection is calculated as follows: Value added at domestic prices - Value added at world prices Value added at world prices.
Till the middle of the sixties the mechanism for appraisal and selection of public sector projects was rather primitive. To improve the quality of project planning and strengthen the public investment decision making process several steps were taken: creation of the Bureau of Public Enterprises; establishment of the Project Appraisal Division (PAD) in the Planning Commission; and institution of the Public Investment Board (PIB).