Economic Analysis

Key Questions
What do we mean by Economic Analysis? Why do we need Economic Analysis? What should be considered in an Economic Analysis?

What is Economic Analysis?

Economic Analysis of a project is to assess the social profit by measuring the effects of the project on the fundamental objectives of the whole economy.

Why do we need Economic y Analysis?

We adopted Economic Analysis to p measure the social profit instead of money profit itself. Economic Analysis of a project provides the decision-maker to allocate their resources more efficiently and effectively.

What should we consider in an Economic Analysis?

Enumeration of Cost and Benefit Measurement of Cost and Benefit Thus it is called CBA.

Economic Analysis: Cost Benefit Cost-Benefit Analysis

Cost-Benefit Analysis (CBA) is a set of procedures for defining and comparing benefits and costs. Decisions are made by decision makers, and benefit-cost analysis is properly regarded as an aid to decision making and not the id d i i ki d h decision itself (Zerbe/Dively 1994).

Cost and Benefit Analysis

Cost-Benefit Analysis involves the consideration of Social Benefits and Social Costs, C t so it i widely used in evaluating and is id l di l ti d assessing many government projects and decisions. In CBA, the Willingness to Pay or to Accept as , g y p measured by the Compensating and Equivalent Variations is the correct theoretical measures for welfare changes changes.

Examples of Public p Projects: using CBA

Pricing non-market goods is common. Community and public goods. where free riders cannot be excluded. Intangible externalities, externalities e.g noise and congestion cost, human lives saved, the pleasure derived by saved passers-by from flowers and trees in private gardens.

THE CBA Approach

Most basically, list all relevant items Value expected benefits and costs Discount the future flow of benefits and costs Appraise the project by setting off aggregate benefits against aggregate cost

Willingness to Pay and to Accept

Consumer Surplus
Consumer Surplus is approximately the amount one would pay for the good, good over what one does pay, rather than do without the good (Zerbe/Dively 1994).
Figure Fig re 1 P

Willingness to pay for a good or to avoid cost is subject to the budget. Willingness to accept payment to forego a good or to bear cost is different from willingness to pay and it could be infinite. Compensation Variation and Equivalent Variation could be adopted to measure the above two concepts. concepts

A P0 B D0 Q0
CS

Source : Ad S Adapted f d from Ri h d O Z b J and D i h D Di l 1994 B fi C A l i In Richard O. Zerbe. Jr. d Dwight D. Dively. 1994. Benefit-Cost Analysis I Theory And Practice. New York: Harper Collins College Publishers, pp. 84.

A: Consumer Surplus B: Payment

Producer Surplus
Producer S l i an amount that can be taken from the producer or P d Surplus is h b k f h d input supplier without diminishing the amount supplied.
Figure 2 Fi P S P0

Measures of willingness to Pay, Willingness to Accept, Consumer Accept Surplus and Producer Surplus

Social benefits and costs are important to evaluate a project as well as important to the policy maker as an reference in undertaking public projects. projects In evaluating the Willingness to Pay and Willingness to Accept, we can adopt the Compensating and Equivalent Variations for measurement. Compensated Demand Curves and Compensating Supply Curves for facilitating our assessment. assessment

PS

Xo

Source : Adapted from Richard O. Zerbe. Jr. and Dwight D. Dively. 1994. Benefit-Cost Analysis In Theory And Practice. New York: Harper Collins College Publishers, pp. 88.

Compensating Variation
It gives the maximum (minimum) amount of money that can be taken from (must be given to) a household so as to leave it just well off as it was before a fall (rise) in price.

Equivalent Variation
It provides the minimum (maximum) amount of money that must be given to (taken from) a household to make it as well off as it would have been after a fall (rise) in price.

Summaries of Compensating Variation and Equivalent Variation

Compensating Variation Money which can be taken or given to leave one as well off as before th economic ff b f the i change Amount he/she would be Welfare willing to pay for the change Gain (finite limited by his (benefit) income) Amount he/she would be Welfare willing to accept as Loss compensation for the change (cost) (could be infinite) Equivalent Variation Money taken or given that leaves one as well off as after the economic change i h Amount he/she would be willing to accept to forego the change (could be infinite) Amount he/she would be willing to avert the change (finite limited by his income)

Expenditure Functions E dit F ti

Expenditure Function is commonly adopted as expressions in much of modern welfare theory.
For a price decrease P 01> P 11 , so that CV > 0 p 1, CV = C[P 01, P 02, U 0)] - C[P 11, P 02, U 0)]
P

a
P1

Compensation Variation

A
P2

CV
b D0

H1 (U1)

H2 (U2)

Source: Adapted from R. Layard and A.A. Walters, Microeconomic Theory, McGraw Hill: New York, 1978, pp.150-152

X4

X3

X2

X1

Expenditure Functions p (Contd)

For a price change P 01 to P 11, EV = C[P 01, P 02, U 1)] - C[P 11, P 02, U 1)]
P

The Rate of Discount

Adopted when we have to forego current consumption presently and obtain the benefits of the project in the future. f t Social Opportunity Cost Applied when we are Rate of Interest (SOC) estimating the future consumption foregone by not taking the alternative investment. Social Time Preference Rate (STP)

a
P1

C
EV

Equivalent q Variation
B X
D0

b P2

H1 (U1)

H2 (U2)

X4

X3

X2

X1

Risk and Uncertainty

Adding premia to the discount rate is a y p p p widely adopted principle.

Economic Analysis for consideration

Steps involved 1. Identify benefits and costs, and quantify 2. Include shadow pricing and opportunity cost, if necessary 3. 3 Apply evaluation methods as in financial appraisal appraisal, e.g. - Discount Cash Flow - Net Present Value - Internal Rate of Return - Benefit-cost ratio

However, not all phenomena exhibit the pattern of riskness. A minor technical adjustment make a possible error in estimating individual items.

Methods of Economic Analysis (Contd)

4. Apply sensitivity and risk analysis Present worth of the expected net social benefit = i=1 PiXi Where Wh Pi = P ibili of an event,Xi = E Possibility f Xi Expected net social d i l benefit

Example E l
There is an existing old and poor single-two road running between Town A and Town B. There is a B proposal to construct a new highway to relieve the increasing traffic on the road. After considering all constraints, a new route has been drawn up for constructing the highway to connect the two towns, crossing a crop field. Identify the social benefits and social costs of the proposed highway project.

Example (Contd)
Social benefits
1. 2. 2 3. 4. 5. Less fuel used by vehicles Less traveling Reduction of maintenance and repair costs to existing road Fewer injuries to pedestrians Benefits from greater business turnover

Difficulties with a CBA

Social costs
1. Costs of resources committed 2. Maintenance and repair costs to new highway 3. 3 Loss of crop production

Allowing for the distributional effects Adjusting market prices to allow for indirect taxes Estimating the willingness to pay for intangibles which are market non-priced Choosing the appropriate discount rate h h d Providing for risk and uncertainty

Conclusion

Like a private investor, the public sector is also concerned about the financial implication of its investments. Market prices do not fully reflect the true costs and benefits of an investment, largely due to market failure and imperfection. Such external effects should therefore be dealt with in economic analysis (always economists refer it to as costbenefit analysis. analysis A financially viable project may not necessarily be economically feasible.