Discuss the UNIDO approach of social-cost benefit analysis

Ans. Towards the end of the sixties and in the early seventies two principal approaches for SCBA emerged: the UNIDO approach and the Little- Mirrlees approach. This section discusses the UNIDO approach; the following discusses the Little-Mirrlees approach.

The UNIDO method of project appraisal involves five stages:

1. Calculation of financial profitability of the project measured at market prices.

2. Obtaining the net benefit of project measured in terms of economic (efficiency) prices.

3. Adjustment for the impact of the project on savings and investment.

4. Adjustment for the impact of the project on income distribution.

5. Adjustment for the impact of project on merit goods and demerit goods whose social values differ from their economic values.

Each stage of appraisal measures the desirability of the project from a different angle.

The measurement of financial profitability of the project in the first stage is similar to the financial evaluation. So, skipping the first stage, the remaining stages are being discussed here.

Net benefit in terms of economic (efficiency) prices

Stage two of the UNIDO approach is concerned with the determination of the net benefit of the project in terms of economic (efficiency) prices, also referred to as shadow prices.The UNIDO approach suggests three sources of shadow pricing,depending on the impact of the project on national economy. A project as it uses and produces resources may for any given input or output (i)increase or decrease the total consumption in the economy, (ii) decrease or increase production in the economy, (iii) decrease imports or increase imports, or (iv) increase exports or decrease exports.If the impact of the project is on consumption in the economy the basis of shadow pricing is consumer willingness to pay. If the impact of the project is on production in the economy, the basis of shadow pricing is the cost of production. If the impact of project is on international tradeincrease in exports, decrease in imports, increase in imports, or decrease

in exports— the basis of shadow pricing is the foreign exchange value.

Shadow pricing of tradable inputs and outputs: A good is fully traded when an increase in its consumption results in a corresponding increase in import or decrease in export or 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 the border price, translated in domestic currency at market exchange rate. The above definition of a fully traded good implies that domestic changes in demand or supply affect just the level of imports or exports.

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 (ii) its export price (FOB price) is less than its domestic cost of production.

The valuation of non-tradables is done as per the principles of shadow pricing discussed earlier. On the output side, if the impact of the project is to increase the consumption of the product in the economy, the measure of value is the marginal consumers’ willingness to pay; if the impact of the project is to substitute other production of the same nontradable in the economy, the measure of value is the saving in cost of production. On the input side, if the impact of the project is to reduce the availability of the input to other users, their willingness to pay for the

input represents social value; if the project’s input requirement is met by additional production of it, the production cost of it is the measure of social value.

Externalities: An externality, also referred to as an external effect, is a special class of good which has the following characteristics: (i) It is not deliberately created by the project sponsor but is an incidental outcome of legitimate economic activity, (ii) It is beyond the control of the persons who are affected by it, for better or for worse. (iii) It is not traded in the market place.

An external effect may be beneficial or harmful. Examples of beneficial external effects are:

(i) An oil company drilling in its own fields may generate useful information about oil potential in the neighbouring fields.

(ii) The approach roads built by a company may improve the transport system in that area.

(iii) The training programme of a firm may upgrade the skills of its workers thereby enhancing their earning power in subsequent employments.

Examples of harmful external effects are:

(i) A factory may cause environmental pollution by emitting large volume of smoke and dirt. People living in the neigbourhood may be exposed to health hazards and put to inconvenience.

(ii) The location of an airport in a certain area may raise noise levels considerably in the neighbourhood.

(iii) A highway may cut a farmer’s holding in two, separating his grazing land and his cowsheds, thereby adversely affecting his physical output.

Since SCBA seeks to consider all costs and benefits, to whomsoever they may affect, external effects need to be taken into account. The valuation of external effects is rather difficult because they are often intangible in nature and there is no market price, which can be used as a starting

point. Their values are estimated by indirect means.The above examples serve to emphasize the difficulties in measuring external effects. In view of this, some economists have suggested that

these effects be ignored. In order to justify their suggestion, they argue that since a project is likely to have both beneficial and harmful external effects, one may not err much in assuming that the net effect would be zero. This argument, seemingly a rationalization for one’s ignorance,

lacks validity. External effects must be taken into account wherever it is possible to do so. Even if these effects cannot be measured in monetary terms, some qualitative evaluation must be attempted.

Measurement of the impact on distribution

Stages three and four of the UNIDO method are concerned with measuring the value of a project in terms of its contribution to savings and income redistribution. To facilitate such assessments we must first measure the income gained or lost by individual groups within the society.

For income distribution analysis, the society may be divided into various groups. The UNIDO approach seeks to identify income gains and losses by the following: (i) Project, (ii) Other private business, (iii) Government,(iv) Workers, (v) Consumers, (vi) External sector.

There are, however, other equally valid groupings.

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.

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:

(i) Given the income distribution impact of the project what would be its effect on savings?

(ii) What is the value of such savings to the society?

Impact on savings of a project is equal to

ΣΔYiMPSi

where, ΔYi = change in income of group i as a result of the project

MPSi = marginal propensity to save of group i

Value of savings of a rupee is the present value of the additional consumption stream produced when that rupee of savings is invested at the margin. The additional stream of consumption generated by a rupee of investment depends on the marginal productivity of capital and the rate of reinvestment from additional income. If the marginal productivity of capital is r and the rate of reinvestment from additional income a, the additional stream of consumption generated by a rupee of investment can be worked out. The consumption stream starts with r (1 – a) and grows

annually at the rate of ar forever. Its present value when discounted at the social discount rate k is:

I =r (1 - a)/(1 + k) +r (1 - a) (1 + ar)/(1 + k)2 + … + r (1 - a) (1 + ar)n-1/(1 + k)n + …

=r ((1 - a)/(1 + k))/1 – (1 + ar)/(1 + k)

=r (1 - a)/(k - ar)

where, I = social value of a rupee of savings (investment)

r = marginal productivity of capital

a = reinvestment rate on additional income arising from investment

k = social discount rate.

Income distribution impact— Many governments regard redistribution of income in favour of economically weaker sections or economically backward regions as a socially desirable objective. Due to practical difficulties in pursuing the objective of redistribution entirely through the tax, subsidy, and transfer measures of the government, investment projects are also considered as instruments for income redistribution and their contribution toward this goal is considered in their evaluation. This calls for suitably weighing the net gain or loss by each groups, measured earlier, to reflect the relative value of income for different groups and summing them.

Adjustment for merit and demerit goods

In some case, the analysis has to be extended beyond stage four to reflect the difference between the economic value and social value of resources.This difference exists in the case of merit goods and demerit goods. A merit good is one for which the social value exceeds the economic value.

For example, a country may place a higher social value than economic value on production of oil because it reduces dependence on foreign supplies. The concept of merit goods can be extended to include a socially desirable outcome like creation of employment. In the absence of the project, the government perhaps would be willing to pay unemployment compensation or provide mere make-work jobs. In the case of a demerit good, the social value of the good is less than its economic value. For example, a country may regard alcoholic products as having social value less than economic value.The procedure for adjusting for the difference between social value and economic value is as follows:

(i) Estimate the economic value.

(ii) Calculate the adjustment factor as difference between the ratio of social value to economic value and unity.

 (iii) Multiply the economic value by the adjustment factor to obtain the adjustment.

(iv) Add the adjustment to the net present value of the project as calculated in stage four.