Social Cost Benefit Analysis

Social

Cost Benefit Analysis is a simple and well known concept. It is based on the assessment of the utility of a project for the society as distinct from the financial and economic utility for the promoter group.

in the latter the focus is limited to financial benefits and costs directly accruing to the enterprise, in social cost benefit analysis the benefits and costs accruing to the society as a whole are considered.
Social

While

Cost Benefit Analysis is to society what profit and loss account is to an enterprise. It is a technique for making enterprise decisions, from societys stand point.

For example
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Now, if we think about the impact of soaps and cigars on the society, the question may be Does the price of cigar take note of the smokers higher probability of cancer? Does the price of soap take note of the benefits from the use of soap e.g. reduced risk of disease spread increases?

Obliviously, a commercial entrepreneur can't give well answer to these questions.

Methodology of SCBA


While the concept of SCBA is simple, the methodology to be adopted for such an analysis is quite elaborate and intricate. As it is based not only on the consideration of quantitative information but also on qualitative information and subjective judgment. To suggest a complete methodology of Project appraisal based on the consideration of costs and benefits two teams of economists were constituted, one by the OECD, consisting of IMD Little & JA Mirrlees and the other by the UNIDO consisting of A.K.Sen, P.Dasgupta and Stephen Marglin.

What is SCBA? :
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Therefore, to reflect the real value of a project to society, one must consider the impact of the project on society .Thus, when we evaluate a project from the view point of the society (or economy) as a whole, it is called Social Cost Benefit Analysis (SCBA)/Economic Analysis

Rationale for SCBA

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: Market imperfections  Externalities  Taxes  Concern for redistribution  Concern for savings  Merit wants


Scope of SCBA :
SCBA can be applied to both public and private investments .
 Public

Investment: SCBA is important specially for the developing countries where govt. plays a significant role in the economic development. investment: Here, SCBA is also important as the private investments are to be approved by various governmental and Quasigovernmental agencies.

 Private

Objectives of SCBA :
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The main focus of SCBA is to determine economic benefits of the project in terms of shadow prices. The impact of the project on the level of savings and investments in the society. The impact of the project on the distribution of income in the society; and The contribution of the project towards the fulfillment of certain merit wants (self-sufficiency, employment etc)

Two Principal Approaches for SCBA :

UNIDO Approach L-M Approach

UNIDO Approach Stage - 1 :

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Calculation of financial profitability of the project -A good technical and financial analysis must be done before a meaningful economic (social) evaluation can be made so as to determine financial profitability. Financial profitability is indicated by the Net Present Value (NPV) of the project, which is measured by taking into Account inputs (costs) and outputs (benefits) at market price.

UNIDO Approach Stage - 2 :

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Obtaining the net benefit of the project at economic (shadow) prices. The commercial profitability analysis (calculated in stage 1) would be sufficient only if the Project is operated in Perfect market. Because, only in a perfect market, market prices can reflect the social value. If the market is imperfect (most of the cases in reality), net benefit of the Project is determined by assigning shadow Prices to inputs and outputs. Therefore, developing the shadow prices is very much vital.

UNIDO Approach Stage - 2 :

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Shadow prices reflect the real value of a resource (input or output) to society as opposed to their financial or market value. Shadow Prices are also referred as economic prices, accounting prices, economic / accounting efficiency prices etc Use of shadow prices is considered essential particularly due to market imperfections, non-market economy, fiscal policy of the state etc. For instance, if the pdn cost of 1 ton of a fertiliser is Rs.2000, though it is supplied to the farmers at a subsidised price of Rs. 1500 only, the point of consideration is whether the cost of fertiliser should be taken as Rs.2000, the actual cost of pdn or Rs.1500, its market price.

Shadow Pricing: Basic Issues

Before we deal with shadow pricing of specific resources, certain basic concepts and issues must be discussed:
1. 2. 3. 4. 5.

Choice of Numeraire Concept of Tradability Source of shadow prices Treatment of taxes Consumer willingness to pay

1.Choice of Numeraire
A unit of account in which the values of inputs and outputs are to be expressed.
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Numeraire is determined at

Domestic currency rather than border price.  Present value rather than future value.  Constant price rather than current price  Consumption use rather than investment use.

2.Concept of Tradability
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A key issue in shadow pricing is whether a good is tradable or not. For a good that is tradable, the international price is a measure of its opportunity cost to the country. For a tradable good, it is possible to substitute import for domestic production and vice versa; similarly it is possible to substitute export for domestic consumption and vice versa. Hence the international price, also referred to as the border price, also represents the real value of the good in terms of economic efficiency.

Why?
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3.Sources of Shadow Pricing

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The UNIDO approach suggests three sources of shadow pricing, depending on the impact of the project on national economy.
If the impact of the project is on Consumption in the economy Production in the economy International Trade Basis of shadow pricing is-

Consumer willingness to pay Cost of production Foreign exchange value

4.Treatment of Taxes
When shadow prices are calculated, taxes usually pose difficulties.The general guidelines in the UNIDO approach w.r.t taxes are as follows:


If the project augments domestic production, taxes should be excluded. If the project consumes existing fixed supply of nontraded inputs, tax should be included . For fully traded goods, taxes should be ignored

5.Consumer Willingness to Pay (CWP) If the impact of the project is on the consumption in the economy, the basis of shadow pricing is CWP
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What a consumer wants to spend for a product or service and what he actually does pay.The difference between CWP and actual payment is called consumer surplus

UNIDO Approach - Stage 2. Shadow Pricing of Specific Resources :

1.Tradable inputs and outputs:- A good is fully traded
a. b.

when an increase in its consumption, results in a corresponding increase in import or decrease in export when an increase in its production, results in a corresponding increase in export or decrease in import. For fully traded goods, the shadow price is border price translated in domestic currency at market exchange rate.

UNIDO Approach - Stage 2. Shadow Pricing of Specific Resources :

2. Non-tradable Inputs and outputs:- A good is non tradable when the following conditions are satisfied
(i)

its import price (CIF price) is greater than its domestic cost of production and its export price ( FOB price) is less than its domestic cost of production.

(i)

UNIDO Approach - Stage 2. Shadow Pricing of Specific Resources :

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Assuming that for a project, one-half of the required input is collected from additional domestic production which has a domestic cost of Rs. 200000 and the rest one half is collected from diversion from other consumers who are willing to pay Rs. 300000. Therefore the shadow price of the inputs will Be: Cost of production + consumer willingness to pay = Rs (200000+300000) = Rs. 500000

UNIDO Approach - Stage 2. Shadow Pricing of Resources :

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Assuming that a newly established power station having a total capacity of 100 million units electricity, charges tariff at Rs. 1 for per unit electricity consumption. The consumers of that particular area are willing to pay Rs. 1.20 for per unit. Therefore, the shadow price is (Rs. 1.20 x10 million) = Rs. 120 million, instead of Rs. 100 million

UNIDO Approach - Stage 2. 3.Externalities

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An externality, also referred to as an external effect (either beneficial or harmful), is a special class of good which has the following characteristics:

It is not deliberately created by the project sponsor but is an incidental outcome  It is beyond the control of the persons, who are benefited or affected by it  It is not traded in the market place


Examples of Externalities
Beneficial effects 1. An oil company drilling its own fields may generate useful information about oil potential in the neighbouring fields. 2. The approach roads built by a company may improve the transport system in the area. Harmful effects 1. A factory may cause environmental pollution by emitting large volume of smoke and dirt, thereby exposing people in the neighbourhood to health hazards . 2. The location of an airport in a certain area may raise noise levels considerably.

Shadow Pricing of Externalities

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Although valuation of external effects is difficult as they are often intangible in nature and there is no market price, their values are estimated by indirect means. For example:
The benefit of information provided by the oil field to neighboring oil fields may be equated with what the neighboring oil fields would have spent to obtain such information. The cost of pollution may be estimated in terms of the loss of earnings as a result of damage to health caused by it and the cost of time spent for coping with unhygienic surroundings.

1.

2.

Shadow pricing of labour

4.Labour inputs

:- The principles of shadow pricing for goods

may be applied to labour as well, though labour is considered to be service.When a project hires labour, it could have 3 possible impacts on the rest of the economy:
I. II. III.

It may take labour away from other employments It may induce the production of new workers and; It may involve import of workers.

If its the 1st case, then the shadow price of labour is equal to what other users of labour are willing to pay for this labour. In a relatively free market this will be equal to the marginal product of such labour.

Shadow pricing of Capital Inputs

5.Capital Investment of capital in a project two things happen 1. Financial resources are converted into physical assets. 2. Financial resources are withdrawn from national pool of savings and hence alternative projects are foregone. Thus, shadow pricing of capital investment involves two questions: y What is the value of physical assets? y What is the opportunity cost of capital(which reflects the benefit foregone by sacrificing alternative project/s)?

Shadow pricing of Capital Inputs

The shadow price of physical assets is calculated in the same manner in which the value of any other resource is calculated. For e.g. If it is a fully traded good, its shadow price is equal to its border price. If its a non-traded good its shadow price is measured in terms of cost of pdn
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The opportunity cost of capital (shadow price of capital) depends on the source from which the capital has generated. For e.g. If the capital is generated from the denial of capital to alternative projects, its opportunity cost is the rate of return that would be earned from those alternative projects.
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Obtaining Net Benefit of the Project at Shadow Prices :

Determining the shadow price of One-shot costs Annual costs Annual benefits Calculating Netbenefit of the project from social point of view.  Here 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  Io = Initial cost at the start of the project
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UNIDO Approach - stage 2. 2.

Obtaining Net Benefit of the Project at Shadow Prices :

An Illustration 1.The Government is considering a project which would supply water for irrigation, generate electricity and provide a measure of protection against floods. The project is expected to have 25 year life time. The costs and benefits of the project are: COSTS: Power equipment costing Rs. 30 crore. (Additional Information: This equipment can be exported at USD 4.5 million. The shadow price of per dollar is Rs. 70)

UNIDO Approach - stage 2. 2.

Obtaining Net Benefit of the Project at Shadow Prices :

2. 30000 tones of cement produced indigenously are used in the project at a cost of Rs 6000.
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(Additional Information: However, one half of the cement will come from additional domestic production which cost Rs. 5000 per ton and one half come from diversion from other consumers who are willing to pay Rs. 6500 for per ton)

UNIDO Approach - stage 2. 2.

Obtaining Net Benefit of the Project at Shadow Prices :

3. Other construction materials (sand, bricks,

steel etc.) cost 20 crore (Additional Information: these materials comes from additional production, production cost of which is 15 crore)

UNIDO Approach - stage 2. 2. Obtaining Net Benefit of the Project at Shadow Prices :
4. Two million man days of unskilled labour for which the project committee decided to pay a daily wage of Rs. 100. (Additional Information: The Shadow Price of unskilled labour is Rs. 80 per day) 5. Skilled labour costing Rs. 5 crore 6. Operating and Maintenance cost of the project will be Rs. 7.5 crore annually. (However, the operating cost should be Rs. 6.5 crore from social view point)

An Illustration : Benefits
1.

0.50 million acres of land will be irrigated. The Government will charge the water levy at Rs. 150 for per acre. (Additional information: the value of additional output acre due to the irrigation will be Rs. 500 per acre).

An Illustration : Benefits
2.100 million Units of electricity will be generated. The electricity will be generated at Rs. 1 per unit (Additional Information:The consumers are willing to pay Rs. 1.5 for per unit of electricity) 3.Flood damages can be saved by Rs. 2 crore annually. However, the Government will not able to collect anything for this.

Obtaining Net benefit of the project :

Cost and Benefit of the Project (at a glance) One-shot cost:

Determining Project Profitability from the Private Angle :

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Net Present Value of a Project is calculated Here

Vt = Annual price of Benefit at time t =17.5  Ct = Annual price of Operating Expenses at time t = 7.5  K = Discount rate = 10%  T = Lifetime of the project = 25 years  Io = Initial cost at the start of the project = Rs. 93


Therefore, the project is generating a negative NPV of Rs. 2.23 crore from Private Angle

Determining Project Profitability from the Private Angle :

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Net Present Value of a Project is calculated .Here

Vt = Shadow price of Benefit at time t =42 Ct = Shadow price of Operating Expenses at time t = 6.5  K = Social Discount rate = 10%  T = Lifetime of the project = 25 years  Io = Initial cost at the start of the project = Rs. 84.75
 

From the view point of society, the project is generating a positive of Rs. 237.48 crore

UNIDO Approach...Stage 3:
Measurement of the Impact on distribution

The purpose of the stages 3&4 are concerned with measuring the value of a project in terms of its contribution to savings and income redistribution.That is to determine the
1.

Amount of income gained or lost because of the project by different income groups (such as project other than business, government, workers, customers etc) Evaluate the net impact of these gains and losses on savings Measure the adjustment factor for savings and thus the adjusted values for savings impact Adjust the impact on savings to the net present value calculated in stage two.

2. 3.

4.

UNIDO Approach - Stage 3 1.Measurement of Gain or loss :

The gain or loss to an individual group within the society as a result of the project is equal to the difference between shadow price and market price of each input or output in the case of physical resources or the difference between price paid and value received in the case of financial transaction.

For e.g. A mining project requires 1000 labourers at a wage rate of Rs. 150 per day.These workers were ready to work for a daily wage of Rs. 100.Therefore, the gain of the group of 1000 workers from the project (150-100)x1000 = 50000 per day.

UNIDO Approach - Stage 3

2. Savings Impact and its value: 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. Stage three of the UNIDO method, concerned with this, seeks to answer the following questions:
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Given the income distribution impact of the project what would be its effect on savings? What is the value of such savings to the society?

UNIDO Approach - stage 3

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Evaluation of the Net Impact on Savings :Net savings Impact of the project = Yi MPSi Here, Yi = change in income of group i as a result of the project MPSi= Marginal Propensity to save a group i Assuming that the income gained or lost by 4 group is
    Workers (W) = Rs. 250000 Consumer(C) = Rs. -700000 Project (P) = Rs 1000000 External (E)=Rs.500000

The Marginal Propensity to Save of these four groups is: MPSw=0.04, MPSc=0.25, MPSp=0.4 and MPSe = 0.3 Therefore, the net impact of the project on savings is: {250000 x0.04+(-700000) x 0.25 + 100000 x 0.4 + 500000x0.3} = Rs. 475000

UNIDO Approach - stage 3 Adjustment Factor for Savings (AFs)

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AFs measure the percentage by which the social value of investment of one Re. exceeds social value of consumption of one rupee. Here,
MPC = Marginal Propensity to Consume MPS = Marginal Propensity to Saving MPcap = Marginal Productivity of Capital CRI = Consumption Rate of Interest (Social Discount Rate)

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UNIDO Approach - stage 3

Adjustment Factor for Savings (AFs)

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Assuming that MPC, MPS, MPcap and CRI of an economy is given: MPC = 70%, MPS = 30%, MPcap=25% and CRI=10% . Therefore, adjustment factor for savings is AFs. Adjusted Value of the impact of the project on savings: Adjusted value of Savings = (Net impact on savings X AFs) = Rs. 475000x6 = Rs. 28,50,000

y y

UNIDO Approach - stage 3

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This Rs. 2850000 is now added to the NPV of the project calculated in stage 2(Rs.237.48 crore) . Therefore, the adjusted NPV at this stage will be Rs. (237.48+.285) = Rs. 237.765 crore

UNIDO Approach Stage 4:

Income distribution impact

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Govt. considers a project as an investment for the redistribution of income in favour of economically weaker sections or economically backward regions. This stage provides a value on the effects of a project on income distribution between rich and poor and among regions. Distribution Adjustment Factor (Weight) is calculated and the impacts of the project on income distribution have been valued by multiplying the adjustment factor with the particular income of a group. This value will then be added to the net present value re-calculated in stage three to produce the social net present value of the project.

UNIDO Approach Stage 4 Determination of Weights

 If there are only two groups in a society, poor and rich, the determination of weight is just an iterative process between the analysts (at the bottom) and the planners (at the top). This is called "bottom-up" approach.  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, 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  n = elasticity of the marginal utility of income

UNIDO Approach Stage 4:

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Assuming that the worker group gains an income of Rs. 250000 from a project, the base level of income is Rs. 50000 which has a weight if 1 and elasticity of Marginal Utility of Income is 0.20. Therefore, weight is value of the impact of the project on income distribution to this group is Rs 250000x0.72 = Rs. 180000 Now this value will be added to the net present value adjusted in stage three. Therefore, Adjusted NPV in this stage will be Rs (237.765x0.018) = Rs. 237.78 crore

UNIDO Approach - Stage 5 Adjustment for Merit and Demerit Goods

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If there is no difference between the economic value of inputs and outputs and the social value of those, the UNIDO approach for project evaluation ends at stage four. In practical, there are some goods (merit goods), the social value of which exceed the economic value (e.g oil, creation of employment etc) and also there are some goods (demerit goods), social value of which is less than their economic value (e.g., cigarette, alcohol, high -grade cosmetics etc) Adjustment to the NPV of stage 4 is required if there is any difference between the social and economic value

UNIDO Approach - Stage 5 :

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The procedure for adjusting the difference between social value and economic value are: Estimating the present economic value. Calculating the adjustment factor. Multiplying the economic value by the adjustment factor to obtain the adjusted value.

1. 2. 3.

4.

Adding or subtracting the adjusted value to or from the NPV of the project as calculated in stage four.

UNIDO Approach - Stage 5 :

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An alcohol factory is being constructed. The present economic value of the project is Rs. 237.78 crore (Adjusted NPV up to stage 4). The output of the project has no social value than its cost of production. Cost of production is the 60% of the economic price. Therefore, adjustment factor is: ((60/100)-1) = -0.4 Therefore, the adjusted value = (Rs. 237.78 crore x - 0.4) = Rs. -95.11 crore The NPV of the project in terms of socially acceptable consumption is (Rs. 237.78 - 95.11) = Rs. 142.67 crore.

Conclusion
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While the adjustment for the difference between social value and economic value is seemingly a step in the right direction, it is amenable to abuse. Once the analyst begins to make a adjustment for social reasons, projects which are undesirable economically maybe made to appear attractive after such adjustment.

While there is no way to prevent such a manipulation, the stage-by-stage UNIDO approach mitigates its occurrence by throwing it in sharp relief.

L-M Approach
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I.M.D. Little and James A. Mirrless have developed an approach to SCBA which is famously known as L-M approach. 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

Despite considerable similarities there are certain differences between the 2 approaches:
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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(border prices) 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.(L-M Numeraire is present uncommitted
social income. L-M methods opt for savings as the yardstick of their entire approach. Present savings is more valuable to them than present consumption since the savings can be converted into investment fore future L-M approach rejects the 'consumption) .

The stage-by-stage analysis recommended by the UNIDO approach fosusses on efficiency,savings and redistribution considerations in different stages.The L-M approach, however, tends to view these considerations together.

Social Cost Benefit Analysis (SCBA)

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The resources of input and output of a project are classified into: Labour, Traded goods & Non-traded goods. Therefore, to find out the real value of these resources, the following values are to be calculated. Shadow wage rate (SWR). Shadow price of traded goods Shadow price of Non-traded goods

a. b. c.

a. Shadow Wage Rate (SWR)

The shadow wage rate is an important but difficult to determine element in SCBA. It is a function of several factors:
  

The marginal productivity of labour The cost associated with urbanisation The cost of having an additional amount committed to consumption when the consumption of a worker increases as a result of the higher income he enjoys in urban employment.

Shadow Wage Rate (SWR)

L-M suggest the following formula for calculating SWR-

SWR= c`-1\s(c-m)
 c`=

additional resources devoted to consumption.  1/s = value of a unit of committed resource  m= marginal product of the wage earner.  c = consumption of wage earner

L-M Approach
b) Shadow price of Traded Goods -Shadow price of traded goods is simply its border or international price. If a good is exported, its shadow price is its FOB Price. If a good is imported, its shadow price is its CIF price. (The logic for using border prices is because it represents the correct social opportunity costs or benefits of using or producing a traded good). c) Shadow price of Non-traded goods- Non-traded goods are those which do not enter into international trade by their very nature. (e.g., land, building, transportation) Hence, no border price is observable for them.

L-M Approach
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Ideally, shadow price of non-traded goods is defined in terms of Marginal Social Cost (MSC) and the marginal social benefit (MSB).
MSC of a good is the value in terms of accounting prices of the resources required to produce an extra unit of the good. For e.g. the MSC of a bus trip is roughly equal to the cost of material inputs(fuel, oil, wear&tear of the bus, etc.) MSB is the value of an extra unit of the good from the social point of view.

 The

 The

L-M suggest that the monetary cost of non-traded goods be broken down into Labour ---- SWR (Social Wage Rate) Tradable ----- SCF (Social Conversion Factor) Residual components ------(SCF)

L-M Approach Accounting Rate of Return (ARR):

This is the rate used for discounting social profits. Experience is the best guide to the choice of ARR . y ARR should be such that all mutually compatible projects with positive present social value can be undertaken
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A Comparative Example of UNIDO and LLM Approach

1.

Power equipment costing Rs 300 million. This equipment can be exported at USD 4.5 million. The shadow price of per dollar is Rs. 70

2. 30000 tones of cement produced indigenously are used in the project at a cost of Rs 6000. One third of the cement will come from additional domestic production which costs Rs. 5000 per ton and two third will come from diversion from other consumers who are willing to pay Rs. 6500 for per ton. The shadow price of per dollar is Rs 70

A Comparative Example of UNIDO AND LM Approach :

3. Other construction materials (sand, bricks, steel etc) cost 200 million. These materials comes from additional production, production cost of which 150 million. 4. Two million man days of unskilled labour for which the project committee decided to pay a daily wage of Rs 100.The shadow price of unskilled labour is Rs. 80 per day.

A Comparative Example of UNIDO AND LM Approach :

5. Skilled labour costing Rs. 50 million. However, this cost reflects what others are willing to pay for the skilled labour. 6. Operating and maintenance cost of the project will be Rs. 75 million yearly. However, the operating cost should be Rs. 65 million from social view point

Benefits
1.

0.5 million acres of land will be irrigated. The Govt. will charge the water levy at Rs. 150 for per acre. The value of additional output per acre due to the irrigation will be Rs. 500 per acre

2. 100 million units of electricity will be generated for domestic use. The electricity tariff will be charged at Rs. 1 per unit. The consumers are willing to pay Rs. 1.5 for per unit of electricity

A Comparative Example of UNIDO AND LM Approach :

3. Flood damages can be saved by Rs. 20 million annually

UNIDO VS. LM Similarities

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Calculation of Shadow prices to reflect social value Usage of Discounted Cash Flow Techniques Taking into account about the effect of a project on savings, investment and income of a society