UNIT 20 COST BENEFIT ANALYSIS

Structure
20.0 Objectives
20.1 Introduction
20.2 Private and Social Costs and Benefits
20.3 The Concept of Shadow Price
20.4 Discounting the Future
20.5 Distributional Concerns
20.6 Government Regulations
20.7 Let Us Sum Up
20.8 Key Words
20.9 Some Useful Books
20.10 Answers or Hints to Check Your Progress Exercises

20.0 OBJECTIVES
After going through this unit, you will be able to:
• define costs and benefits;
• distinguish between private and social costs, and private and social benefits;
• explain the concept of shadow price; and
• describe how decisions regarding implementing a project in undertaken.

20.1 INTRODUCTION
Cost-Benefit analysis (CBA) is a technique which is used to appraise and evaluate
projects. The basic idea in CBA is quite simple: first identify the costs and benefits
of a project and then measure them in comparable units (say in terms of money, and
expressed in a single currency). Compare the benefits and the costs. If the benefits
exceed the costs, the project should be accepted as resource allocation will be
efficient. If, on the other hand, costs exceed benefits, then reject the project.

The desirability or feasibility of projects, whether in the private or public sector are
adjudged on the basis of criteria that are rooted in the concept of profits. Profitability
is contingent upon the likely costs that the project entails, and the likely returns that
it generates. The two sectors, public and private, however may differ (sometimes
widely) on the explicit recognition of the prices at which the value of output and the
cost of inputs are to be evaluated. While the analysis of projects in the private sector
generally incorporates the direct and financial costs and benefits only, the analysis of
public sector projects attempts to encompass the indirect and non-financial costs
also.

However, once prices of both inputs and outputs are agreed upon, any project for
which revenues exceed the cost is desirable. However, since resources are finite,
those that generate the maximum profitability would get priority. To evaluate
projects over a lifetime, we must have its returns as well as costs in all future periods.
When the private sector is faced with a choice between more than one project, it has
to rank projects in terms of profitability. The net present value (NPV) is one such
criterion to evaluate a project. For any project which has a cost C, in the present
period and a return of R over the coming two periods and if r be the market interest
rate, then the net present value of a project would be
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NPV= – C + R/(1+r) + R/(1+r)2 Cost Benefit Analysis

If the net present value of the project is positive, it should be undertaken; if not, then
not. If there is a choice between more than one project, the one with the highest net
present value should be chosen. Another measure of profitability is the internal rate
of return (IRR), which is that rate of interest which makes the net present value equal
to zero. If the internal rate of return is higher than the net present value, the
investment is worth undertaking; if not, then not. However, since the internal rate of
return gives no indication of size. It may sometimes be better to undertake projects
with lower internal rate of return, if the magnitude of the project is of concern.

The difference in the analysis of projects across sectors arises out of choice of prices
to estimate profitability (feasibility/ desirability). In most private sector projects, the
prices chosen are the prevalent and observable domestic market prices. However,
these prices are largely perceived to be inappropriate to adjudge the feasibility of
public sector projects.

20.2 PRIVATE AND SOCIAL COSTS AND

BENEFITS
Cost Benefit analysis starts with the premise that receipts are not exactly a measure
of social benefits and neither are costs incurred a measure of social costs. Only under
certain hypothetical conditions will the two merge, and in such a situation private
and social profit would coincide.

Such a coincidence will happen if there is full employment of resources. Any extra
output or project that has to be undertaken will result in drawing out inputs from
another production chain or project and an increase in output in the current project
has to be weighed against the loss in output from where the resources have been
drawn out. Markets would have to be perfectly competitive such that, individual or
firm behaviour will not change prices or wages. Not only should benefits follow
from a project it will be necessary to analyse to whom the benefit accrues to. A rupee
going to a rich man may be given lesser weight than a rupee going to a poor man,
given that the poor man values the rupee more. There is also the question of
consumer’s taste over the choice of the society at large.

Private and social costs and benefits will differ not only on account of the private
sector not taking into account the costs and benefits accruing to all sections of
society, but to the fact that they face different prices coming from distortions within
the system. Such distortions give wrong incentives to private producers for
investment from the social point of view. The two measures of distortion are: i) the
effective protection rate, and ii) the domestic resource cost. The effective protection
rate is defined as the ratio of difference between value added at domestic prices and
⎛ VA d − VA w ⎞
that at world prices to the value added at world prices that is ⎜ ⎟.
⎝ VA w ⎠
Therefore, if domestic prices are equal to international prices, the effective rate of
protection is zero. The domestic resource cost is the amount of domestic resources of
an industry to produce a net unit of foreign exchange. These measures although
useful have limitations in the sense of its inadequate treatment of non-traded goods
and inadequate treatment of factors.

Social costs differ a lot from private costs due to distortions in prices. Let us consider
the Indian situation a few years ago when the exchange rate was fixed by the
government. Since the government was keen on industrialisation, the exchange rate
was over-valued. That is when the free market rate was Rs. 50 to a dollar; the
government was selling it at Rs. 40 to a dollar. So for every dollar worth of good
bought by importers, the government was losing Rs. 10. Therefore, importers bought
more machinery at Rs. 40 to a dollar than they would have at Rs. 50, and the cost
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Development Strategies was borne by the government. If $1 M worth of goods were imported, 10M rupees
worth of tax revenues were forgone, which could have been used to provide public
goods to citizens.

Power and fertilizer subsidies are a few other examples where inappropriate pricing
policies have lead to a huge misallocation of resources. For example, the soil and
climatic conditions in Northern India is fit for the cultivation of sugarcane – a water
intensive crop, than Western India which is relatively dry. However, availability of
cheap power subsidies in Maharashtra, has meant overuse of ground water resources
by use of deep tube wells to grow sugarcane and a lowering of the water table in
these areas. The cost of growing sugarcane in these regions is not just the subsidy bill
being footed by the government; it also must include the higher cost to be paid for
water in these areas.

Similar is the situation with fertilizer subsidy. In order to encourage agricultural

output by use of fertilizers, the government gives a fertilizer subsidy. In such
situations, farmers have found it profitable to grow high value crops, which would
not have been possible in the absence of a subsidy. There have been instances of
overuse of fertilizers by farmers leading to water sources being contaminated by
nitrates. The cost of growing such crops must not only include the subsidy bill but
also the higher costs due to pollution which comes about from such policies.

Concessions given to industries in the form of cheap land and subsidised transport
costs to set up industries in backward regions have to be also seen from the
perspective of a cost benefit analysis. In the absence of such concessions, industry
would have found it unviable to set up operations. Such project appraisals have to be
done taking into account the profits generated to entrepreneurs, the incomes as wages
and salaries to locals which would have been difficult to generate otherwise, the
subsidy cost being borne by the government in the form of cheap land and transport.

Decisions on freight transport by public sector companies also get distorted due to
faulty pricing policies. In pricing decisions by Indian railways, the government has
subsidised passenger travel by over-charging freight in Indian railways. As a result,
much of the freight has moved from rail to road in India. Railways are a much
cheaper option than road, given that the former uses coal as fuel rather than oil.

20.3 THE CONCEPT OF SHADOW PRICE

Therefore, while analysing investment decisions by firms, the set of correct prices by
which it needs to evaluate is usually the ‘shadow price’. The shadow price of a good,
is the net impact on social welfare of a unit increase in the supply of the good by the
public sector. This idea was developed by Ravi Kanbur and welfare changes are
evaluated by using a ‘social welfare function’ which is a mathematical expression of
inter-temporal and inter-personal distribution of consumption. Such a social welfare
function would take into account both the growth as well as the distributional
concerns in society. Growth envisages transformation of present consumption into
future consumption, whereas equity envisages present consumption from the rich to
the poor.
The method used for shadow price calculation in this unit is based on a set of rules
and guiding principles formalized in the Cost-Benefit manuals by Little and Mirrlees
(1974) and Squire and Van der Tak (1975). These principles are summarised as
follows:

• The shadow price for tradable goods should be based on world or border prices.
• The shadow price of non-tradable goods should equal the marginal social cost of
production.
• The shadow price of factors should be based on the social opportunity cost in
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• Income distributional consequences should be explicitly incorporated in Cost Benefit Analysis
evaluating the shadow price.
However, there are limitations in the exercise of the computation of shadow prices.
There are subjective judgements involved in modelling the economy, which however
is not special to this exercise alone. This would be present in almost all economic
analysis. Differential effects of large scale and small scale sectors on output and
employment cannot be resolved due to lack of such detailed data. Other than the data
availability and data quality limitations, certain technical details need to be
understood. Public Income that is earmarked for a certain project (one which is not
easily available) is less valuable than the income that can be put to 'any' use. Income
available in the form of freely convertible currency is more valuable, than one in the
domestic currency which may not be freely convertible. The numeraire should
ideally be the uncommitted public income measured in convertible currency (free
foreign exchange, valued at the official exchange rate). The numeraire should be
such that it retains a constant purchasing power; as such it entails a description of a
bundle of goods and also a measure of a composite price index of this bundle
(measured by the change in the value of this bundle at accounting prices). The price
index, like the welfare function, should be evaluated for different groups/classes of
income earners. Also, the bundle of goods and services for each class should be the
one that is bought at the margin of consumption expenditure. Despite all its
weaknesses, this framework has the advantages of a greater feasibility of working at
a greater level of dis-aggregation than would be possible in the case of a general
equilibrium model. The data requirements are reduced to a more manageable level.

Check Your Progress 1

1) What are the reasons for the divergence of private costs and social costs?

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2) Explain the concept of shadow prices.

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20.4 DISCOUNTING THE FUTURE

Apart from the problem of choosing appropriate shadow prices, there is also the
problem of choosing an appropriate discount factor, to value the future. If capital
markets were perfect, the market interest rate would reflect the proper discounting of
the future. Given the distortions in the system of taxes and subsidies, the social rate
of discount is different from the market rate of discount captured by 1/(1+r), where r
is the market rate of interest. While deciding on an incremental saving ∆S,
households expect an incremental consumption of ∆S(1+r). Similarly incremental
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Development Strategies expenditure of ∆C by firms would lead to an incremental gross revenue ∆R. The
after tax incremental net revenue would be ∆R(1-t) and this should at least be equal
to ∆C(1+r) for the investment to be undertaken. Therefore only for a gross
investment of ∆C(1+r)/(1-t) would the investment be undertaken. Therefore an
amount of resources ∆S+∆C invested today gives ∆S(1+r)+ {∆C(1+r)/(1-t)}.
Therefore, the rate that is applicable in this situation is ∆S(1+r)+ ∆C(1+r)/(1-t)- ∆S-
∆C/ ∆S+∆C. Note that in the absence of taxes, this rate would exactly equal the
market rate of interest r, and therefore the appropriate social discount rate can be
computed.

The social discount rate in this situation was easy to compute as the returns in future
periods were assumed to be known for certain. In many circumstances, the returns
cannot be evaluated for certain. There are delays in the completion and
implementation of a project leading to escalation in costs. Some of the negative
effects of a project such as the extent of environmental damage due to the
implementation of hydro-electric projects, the costs to a society due to submergence,
come out clearly only once the project is over. In such cases we would have started
with an improper computation of the social discount rate. In such cases lengthy
debates arise before the implementation of such projects and people take extreme
positions.

It is not only in the context of risky projects that one is unsure of the proper discount
rate to be taken into account. Take higher education for instance. Even if one does
not have the resources today to undertake higher investment, it may make sense for
any individual to go for higher education by borrowing today, taking into account the
future income streams that will come about. However, if people are unsure of their
job prospects after the investment, they may not choose to go for it. In this situation
there is a case for subsidising education by the government, such that anybody who
is academically able goes for it and the society as a whole achieves a higher income
level in the long run. Likewise even in the sphere of health, individuals by
themselves may not invest enough in medical insurance, and preventive healthcare.
This increases the probability of incidences of disease and accidents in the future,
and in this case public provision of health care may be advocated to take account of
the gains reaped by society in the long run.

20.5 DISTRIBUTIONAL CONCERNS

The differential impact of any project on the population is also a matter of concern in
cost benefit analysis. Normally by Pareto criterion, if a project leaves some people
better off and no one worse off it is acceptable. However, even such projects which
are acceptable by the Pareto criterion, may be opposed on the ground that it increases
inequality. A standard measure of inequality is the Gini coefficient which is based on
the sum of absolute income deviations between all possible pairs of individuals in
society. Think of a situation before the project of 5 individuals, where 4 persons have
no income and one person has 10 units. If after the project 2 persons have 10 units
and 3 have none, then although this situation is better from the Pareto criterion,
inequality would increase after the project. This is because there is an absolute
income difference of 10 units each with the person who has income now and did not
have it before and persons who still do not have it. This absolute difference between
these pairs was zero before the project was undertaken.

A standard way to evaluate the welfare implications of a particular project would be

from a utilitarian perspective implying greatest good for the greatest numbers. Since
marginal utility is more to a poor individual rather than to a rich, welfare from a
utilitarian perspective is maximized if more resources from any investment is
directed towards the poor, such that the marginal gain from a project is equal for all
individuals.

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If after the implementation of a project, the poor in a society become worse off, the Cost Benefit Analysis
project would be evaluated to have imposed a net cost to society from the Rawlsian
perspective. A society would be thought to have attained its peak, when the worst off
person becomes the best off in society. It would therefore imply that individuals from
a society agree to a wealth distribution such that all individuals attain the same
welfare. Therefore, from a Rawlsian perspective, the benefits from any project are its
impact in improving the welfare and incomes of the poorest of the poor in society.
By both the Rawlsian and the utilitarian perspective a transfer from the rich to the
poor results in welfare gain although both perspectives differ on the extent of transfer
that would maximize the gains in society.

Check Your Progress 2

1) Discuss the method of discounting in cost benefit analysis.

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2) How would you address problems of distribution in cost benefit analysis.

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20.6 GOVERNMENT REGULATIONS

Government regulations are so designed to ensure that policies undertaken in such a
framework results in the largest aggregate social benefit: i) it undertakes policies to
ensure that society does not experience widespread unemployment; ii) it follows a
progressive tax system to ensure equity to a certain extent, iii) it sometimes offers
minimum support price for certain agricultural goods to ensure a steady production,
and iv) it undertakes rules and regulations to ensure that external dis-economies are
minimised. For example it might impose taxes on factories causing air pollution for
the benefit of the society at large. It is assumed that when private entrepreneurs
operate with a profit motive in a proper regulatory framework, the best results are
obtained.

In an effort to develop fast, most developing countries have paid good attention to
industry and agriculture while neglecting health and education. Huge investments in
large projects create a shortage for scarce capital resources, leading to inflationary
tendencies in the economy. In such cases, governments might have to resort to price
controls, in order to encourage investments in sectors that would have been relatively
unprofitable. With inflation, and with government managing the exchange rate, our
exports become uncompetitive. The government therefore needs to devalue currency
at suitable intervals of time. Interest rates in developing countries have a wide
variation, coming out of distortions from within the system and therefore the need for
government intervention. Large projects might be undertaken in developing countries
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Development Strategies since they may have positive feedbacks in other sectors of the economy in which
case its profitability cannot be an indicator of the net social benefit. In order to
encourage such projects the government might have to give suitable incentives.
Developing countries normally earn their export earnings from very few
commodities, which make them susceptible to external price shocks. In order to
diversify the export basket, the government might give suitable subsidies to
producers of a wide variety of export products. Investment may be in short supply in
developing countries due to lack of savings, in which case the government may act
by giving suitable tax breaks if individuals invest in particular saving schemes.

Check You Progress 3

1) Let the government opt for a program of mass immunisation (as in the case of
polio eradication) which may be financed by public money, but the medicines or
vaccine (polio drops) may be procured from the public sector producers and the
administration and also the administration of the vaccine may be contracted out.
Evaluate this program to one where private parties opt for the vaccine. In your
answer take account of the following:

a) the probability of infection in the absence of immunisation drives.

b) the loss of earnings capacity of an infected person.
c) the direct cost of the medicine.
d) the improved productivity and man days saved on account of the
immunisation.
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2) State some important areas in which the government intervenes in

developing ****

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20.7 LET US SUM UP

This unit discussed the standard measures of project evaluation, namely the net
present value and the internal rate of return. These measures are very sensitive to the
choice of prices at which both outputs and inputs are evaluated and the choice of
discount rates. The public sector and the private sector may have different valuations
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for inputs and outputs, and in this context the notion of shadow cost comes in useful Cost Benefit Analysis
which reflect the true cost to society. While thinking of benefit as well as cost, we
also need to take into account as to which section of the society gains and which
section loses due to the implementation of a project, such that suitable compensation
measures can be made in order for the project to be undertaken. Finally, since the
real world is far from perfect in the sense that social and private profits would
converge, the government might have to come up with appropriate interventions and
regulations under which individuals and private entrepreneurs operate, such that
actions taken under such an environment result in the largest social good.

20.8 KEY WORDS

Discount Factor: A number with

Shadow Prices: These are prices that do not benefit exist in the market but are the
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Social Discount Rate: The discount rate computed keeping in mind social costs and
benefits.

20.9 SOME USEFUL BOOKS

Dasgupta, A.K. and Peace, D.W. (1972), Cost Benefit Analysis Theory and Practice.
Macmillan, London

Dinwiddy, Carolive and Teal, Francis (1996), Principles of Cost Benefit Analysis for
Developing Countries, (UK. Cambridge)

Kirkpatrick, Colin and Weiss, John (eds.) (1996) Cost-Benefit, Analysis & Project,
Appraisal in Developing Countries, Edward Elgar, Chellentian UKA Brookfield,
Vermont, US

Little, I. M. D.and Mirrlees J.A.(1974) Project Appraisal and Planning for

Developing Countries. Heinamann Educational Books Ltd., London

Stiglitz Joseph, (1988) Public Sector Economics, (2nd edn.) W.W. Norton and
Company , New York

20.10 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1

1) See Section 20.2

2) See Section 20.3

Check Your Progress 2

1) See Section 20.4

2) See Section 20.5

Check Your Progress 3

1) See Section 20.6

2) See Section 20.6 29