SOCIAL COST BENEFIT ANALYSIS

Present By DR P R KULKARNI
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PROJECT APPRAISAL : THREE COMPONENTS

Financial Appraisal :examines the financial flows generated by the project itself, and the direct costs of the project measured at market prices.
Economic Appraisal: adjusts costs and benefits to take account of costs and benefits to the economy at large, including the indirect effects of the project that are not captured by the price mechanism. Social Appraisal: examines the distributional consequences of project choices, both inter-temporal concerns (i.e. effects over a period of time, today versus the future); and also intra-temporal concerns (e.g. concerns between groups in society at a specific point in time).
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Rationale for SCBA

It provides a rational framework for project choice using national objectives and values. The choice of one project rather than another must be viewed in the context of their total national impact in term of employment, output, consumption, saving, foreign exchange earning, income distribution, and other things of relevance to national objectives. Social costs and benefits of the project is the primary focus of the SCBA and they tend to vary from monetary costs and benefits of the project. Some of the principal sources of discrepancy are :
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Principal Sources of Discrepancies for SCBA

Market Imperfections Externalities Taxes and Subsidies Concern for Savings Concern for Redistribution Merit Wants
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Significance of SCBA

Basis of Evaluation :
Prices that would be appropriate for social calculation It helps t understand cost & benefit of project- directly and indirectly.

Enables Decision Making:

It is not technique. It is approach. It provide rational framework for project choice using national objectives. Projects are judged in term of precise impact on economy.

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UNIDO Approach for Social Cost Benefit Analysis

United Nations Industrial Development Organization (UNIDO) Five stages Calculation of financial profitability at market price Shadow pricing of resources to obtain the net benefit at economic prices Adjustment for the projects impact on saving and investment Adjustment for the projects impact on income distribution Adjustment for the projects production or use of goods whose social values are less than or greater than their economic values
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Concept of Shadow Pricing

In perfect market conditions Market prices only reflect the shadow prices In imperfect market conditions Shadow pricing is done in terms of two criteria: Which resources figure most prominently in the benefits and costs of the project at market prices? What are the resources whose market prices are significantly different from the shadow prices?
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Items for Shadow Pricing

Main Outputs : They constitute the entire benefit stream if there are no externalities and are often sold at protected prices Importable Material Inputs : If produced domestically, they may enjoy substantial protection, if imported, they may be heavily taxed Major Non-Imported Material Inputs : Involve tradable material content that is protected Unskilled Labor : Its market wage often exceeds its shadow wage
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Basic Issues of Shadow Pricing

Tradability : A good is said to be tradable if it can be imported instead of domestic production and if it can be exported instead of domestic consumption. Its real value to country in terms of pure efficiency of such good is the international price. Major categories of Tradability: Tradable A good that would be imported or exported in the absence of trade barriers.

Non-Tradable A good whose real domestic cost of production is too high to permit export and too low to motivate import

Traded A tradable that is actually traded

Non-Traded A tradable that is not traded because of trade policies
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Contd
Sources of Shadow Prices

In Perfect market conditions Market Price Tradable inputs and outputs: International Price Non Tradable inputs and outputs :Willingness to pay is relevant shadow price . Labor inputs : Economic Efficiency. Capital Inputs : If it is fully traded goods value of its border Price. If it is partially traded or non traded its shadow price is its economic cost production
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Contd
Treatment of Taxes

Fully traded goods Taxes should be ignored

Non-Traded consumer goods Taxes should be included as part of the indication of the consumer willingness to pay the marginal economic value

Taxes should be excluded if the project increases the production by other domestic producers
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Contd
Externalities These are special class of non-traded goods that may be either positive or negative Positive Externalities Workers training but beneficiary pay no charge Negative Externalities Air pollution but those adversely affected are not compensated Herein the Shadow price is the economic value Economic value (in this case) = NPV+ Net cash flow

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Contd

Foreign Exchange The Shadow price of foreign exchange = Fi * 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 the unit of foreign exchange Pi = Domestic market clearing price of commodity

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Stage III Distribution of Benefits over Time The Savings Impact

Difference between consumption and saving Vital consideration to make a choice Rationale behind this stage Amount of income gained or lost Marginal propensity to save Rate of return

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Stage IV- Income Distribution Impact

In many countries the redistribution of income to specific income classes is high priority. Because Government is not able to accomplish the distribution more efficiently. It is therefore important to measure the impact of the project from this point of view. The net gain and loss of each group is calculated.
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Stage V- Merit and Demerit Goods

Merit Goods :if the social value of the goods is more than its efficiency value , goods may called a merit goods For instance a country may want foreign exchange simply to increase its ability to withholds its export for strategic political reasons. Demerit Goods : if the social value of the goods is less than its efficiency value than that goods may be called as a demerit goods. Country may include tobacco, alcohol and luxury good items in this category.
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LITTLE MIRRLEES APPROACH

SIMILARITIES TO UNIDO APPROACH

Calculation of accounting (shadow) prices for foreign exchanges savings and skilled labor Consideration of factor of equity Usage of discounted cash flows analysis

DISSIMILARITIES TO UNIDO APPROACH

Measures cost and benefits in terms of international prices Measures costs and benefits in terms of uncommitted social income Considers efficiency, savings and redistribution together for analysis

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Inputs and outputs

The inputs and outputs in the project are classified: Traded good and services. Non traded goods and services. Labor

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SHADOW PRICES

Shadow Prices of Traded Good is its border price Shadow Prices of Non-traded Goods are defined in terms of marginal social cost and benefits. Calculation of marginal social cost and benefits is practically difficult L-M approach has suggested that the monetary cost of non traded items should be broken down into tradable , labor & residuals Shadow Wage Rate. The accounting rate of return should used for discounting social benefits.
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EXAMPLE:
A multiple-purpose river valley project has been proposed by a government. The requirements of the project are 4,00,000 tonnes of cement produced indigenously and supplied at a rate of Rs.800 per tonne. 30 mn man days of unskilled labor at daily wage rate of Rs. 12 20,000 tonnes of steel produced indigenously at a cost of Rs.6,500 per tonne The annual benefits excepted from the project would be: 300 mn units of electricity will be generated Flood damages to the extent of Rs.30 mn will be saved annually

The following additional information is available Steel is a tradeable item whose FOB value is $ 450/tonne The shadow price per dollar is Rs.13 Cement is not a tradeable item The shadow price of unskilled labor is Rs.8 per day The electricity tariff charged by the project central board would be 35 paisa per unit. The consumer willingness to pay is 50% more than the tariff charged.
Define the cost and benefit from the project control boards and economic point of view.

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Social Cost Benefit Analysis by Indian Financial Institutions

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IDBI

Projects evaluated also with Social Angle Uses three concepts

Economic rate of return Effective rate of protection Domestic Resource Cost

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Economic Rate of Return

IBDI follows a modified version of little L-M approach to Social cost benefit analysis. Input and out are calculated by following methods. All non labor inputs and outputs are valued at international prices. The international prices reflects true economic value. In case of tradable items for which international prices are directly available , international prices are used. For tradable items whose international prices are not available social conversion factors are used. The rupee value of each good is divided into tradable, non tradable & residual components. Social conversion than applied to these components
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Proportions of Tradable (T), Labor (L) & Residual (R) and Social Conversion Factors (SCF)

Item

Proportion

Land
Building & Construction Indigenous Equipment Transportation Engineering & Know How fees Bank Charges Preoperative Expenses

SCF=1/1.5
T=0.5, L=0.25, R=0.25 SCF=0.70 T=0.65, L=0.25, R=0.10 SCF=1.50 SCF=0.02 SCF=1.00

Labor
Salaries Repairs & Maintenance Water, Fuel, etc (Utilities) Electricity
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SCF=0.50
SCF=0.80 SCF= 1/1.5 T=0.50, L=0.25, R=0.25 T=0.71, L=0.13, R=0.16
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Proportions of Tradable (T), Labor (L) & Residual (R) and Social Conversion Factors (SCF) (Contd.) Domestic Stores SCF=0.80 Other Overheads SCF=1/1.5

The SCF of tradable, labor

Tradable Component

& Residual components is the same for all goods

1/1.5

Labor Component
Residual Components

0.5
0.5

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Example on SCB Appraisal of a Project

Projects aims to produce a product which is imported. Life of project is 8 years. Output of the plant to substitute the whole import. First, appraise the capital expenditure Secondly, Appraise the annual statements Calculate IRR of the cash flows of Social Benefit. If, the required Social discount rate is less than IRR, accept the project else reject it

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Capital Expenditures
(Rs. Crores)

Land Building P&M (Imported) (CIF Value = 9 Crore) P&M (Indigenous) (CIF Value of similar items = 50 Crore) Transportation Costs

0.5 11.00 7.00 60.00 2.00

Technical Know How Costs

Pre operative expenses Bank Charges

6.00
5.00 0.50

W.C Requirements (CIF Value = 15 Crore)

Total
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112
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Calculations
Basis of Conversi on SCF=1/1.5 T, L , R CIF CIF T, L , R SCF=1.50 SCF=1.00 SCF=0.02 CIF Tradable Valu e Ab Initio T 0.33 9 60 9 5 0.01 15 98.34 5.5 1.3 6.8

Item Land Building P&M (Imported) P&M (Indigenous) Transportation Costs Technical Know How Costs Pre operative expenses Bank Charges W.C Requirements Total

Financial Cost 0.5 11 7 60 2 6 5 0.5 20 112

L 2.75 0.5 3.25

R 2.75 0.2 2.95

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Calculation of Social Value of Capital Expenditure

Rs ( Crores)

Tradable Value Ab initio

Social Cost of Tradable component(6.8/1.50) Social Cost of Labor Component (3.25*0.50)

98.34
4.53 1.63

Social Cost of Residual Component (2.95*.50)

Total Social Value of Capital Expenditure

1.48
105.98

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Annual Statements
Income (Rs. Crores)

Net Sales (15,000 tonnes @ Rs 90,000/tonne, CIF Value = 80,000/tonne)

Expenditure Imported R.M. (CIF Value = 7 crore) Indigenous R.M. Labor Salaries Repairs & Maintenance Water, Fuel, Etc. Electricity (Rate=4, Duty =2) Depreciation Other Overheads

135

9 70 7 5 3 7 6 10 8

Taxable Profit
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Calculations
Basis of Conve rsion CIF SCF=0.80 SCF=0.5 SCF=0.80 SCF=1/1.5 Tradable Value Ab Initio 7 56 3.5 4 2

Item Imported R.M. Indigenous R.M. Labor Salaries Repairs & Maintenance

Financial Cost 9 70 7 5 3

T -

L -

R -

Water, Fuel, Etc.

Electricity Other Overheads Total
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6 8

T, L, R
T, L, R SCF=1/1.5

3.5
2.84 5.33 6.34

1.75
0.52 2.27

1.75
0.64

77.83
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Calculation of Social Cost of Annual cash flows

Rs ( Crores) Tradable Value Ab initio Social Cost of Tradable component(6.34/1.50) 77.83 4.23

Social Cost of Labor Component (2.27*0.50)

1.14

Social Cost of Residual Component (2.39*0.50)

1.20

Total Social Value of Capital Expenditure

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84.40
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Calculation of Social Cost of Annual cash flows (Contd.)

CIF Value of Output @( Rs. 80,000/ tonnes x 15,000 tonnes) = 120 Crores. Net Social Benefit P.A = 120 84.4 = 35.60 Crores. In the final year W.C Liquidation = 15 Crores Salvage value of Assets = 2 Crores

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IRR Calculation
Year Cash Flows

0 1

-105.98 35.6

2
3

35.6
35.6

4
5 6 7 8 IRR
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35.6
35.6 35.6 35.6 52.6 30.08%
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Effective Rate of Protection

The Government protect domestic industry through means such as taxes &tariffs, import and export restrictions. The degree of protection given to industry provides an idea, How vulnerable the industry is? The degree of protection available to industry is judged by value added made by industry at domestic and at world price.

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Effective Rate Of Protection-Formula

ERP = Value added at domestic prices - Value added at world prices Value added at world prices Value added = Selling price Inputs cost The traded inputs are valued at both world prices and domestic prices while the non traded inputs are valued only at the domestic prices.

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Valuation of Gods

Traded goods are valued at both world price and domestics price. Non traded goods are valued only at domestics price. The classification of inputs into tradable &non tradable goods: Raw materials and stores: These in general treated as traded goods and also valued at world price.

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Cotinu..

Power fuel and water: These are treated as a non traded goods. If fuel cost is significant it should be valued at both at domestic and world price. Repairs and Maintenance: Generally a non traded item but value of spares consumed is considered both domestic and world price. Selling Expenses: Non -traded items. Administrative Expenses: The expenses like rent, telephone, and telegraph etc are treated as non- traded expenses.
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Domestic prices Inputs Tradable inputs Raw material Consumable stores Non tradable inputs Power fuels and water Repairs and maintenance Administrative overheads Selling expenses Total input cost Output Sales realization Value added 750 95 35 20 45 30 655 450 75

World Prices

350 40

390

450 60

ERP = (95-60)/60*100 = 58.33%

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Domestic resource cost

It is the spending required in terms of domestic currency to generate a saving of one unit of a foreign currency. The commonly used foreign currency for estimating DRC is the US dollar.

DRP = Value added at domestic prices * Exchange rate

Value added at world prices

The amount of value added for computation of DRC is estimated as follows:

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Domestic Selling Price Less: Operation cost

International

Raw materials
Power fuel water Repairs and maintenance Administrative Overhead Selling expenses Less: capital costs Charge on capital employed

Depreciation

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Relation Between ERP and DRC DRC = (ERP + 1)* Exchange rate Assuming Exchange rate, 1 USD = INR 45 DRC = (0.5833 +1)*45 = INR 71.25

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Following details available in respect of project

Rs crores
Value of tradable inputs in domestic price Value of non- tradable inputs at domestic price Value of tradable inputs at world price 700 180 560

Sales realization at domestic price

Sales realization at world price

1000
800

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Calculate ERP Calculate DRP at Exchange rate Rs 26 per dollar

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solution At domestic price 1000 700 180 120

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At world price

Selling price Input cost tradable goods Input cost non tradable goods Value Added
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800 560 180 60

45

ERP= 120-60/60 * 100 = 100% protection DRC=Value added at domestic price/ Value added at world price * Exchange Rate DRC =120/60*26 = Rs52

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