L-M Approach in Social Cost-Benefit Analysis (SCBA)

L-M Approach

I.M.D. Little and J.A. Mirlees developed this approach for analyzing Social Cost-Benefit Analysis (SCBA), as presented in their works Manual of Industrial Project Analysis in Developing Countries and Project Appraisal & Planning for Developing Countries. The method is widely recognized as the L-M Approach.

The central idea of this approach is that the social cost of using a resource in developing countries often differs significantly from its market price. To capture this difference, the approach employs shadow prices, which reflect the real value of resources to society.

Key Features of the L-M Approach

1. Numeraire: The L-M numeraire is present uncommitted social income.
2. Savings as Yardstick: The approach gives greater importance to savings over consumption. This is because savings can be transformed into future investments, making them more valuable than present consumption.
3. Rejection of UNIDO Numeraire: Unlike the UNIDO approach, which uses consumption as the standard, the L-M approach rejects this idea. Little and Mirlees argue that consumption at all levels is valuable, so a focus on savings and investment better reflects social benefits.
4. Use of Border Prices: Costs and benefits are measured in terms of international (border) prices, as these reflect the true social opportunity cost or benefit of producing or consuming traded goods.

Why Border Prices?

Border prices (FOB for exports and CIF for imports) are used because they accurately represent the social opportunity cost of traded goods in developing economies.

Application of L-M Approach in SCBA

Resources involved in a project are broadly classified into:

1. Labor
2. Traded Goods
3. Non-traded Goods

To evaluate their real value, the following shadow prices are calculated:

1. Shadow Wage Rate (SWR)

The SWR measures the opportunity cost of employing an additional worker in a project. It considers:

• The value of output forgone due to employing labor.
• The cost of additional consumption caused by labor transfer.

Formula (as suggested by L-M):

Where:

• m = marginal productivity of the worker
• c′ - c = cost of urbanization (e.g., housing, transportation infrastructure)
• (1 - 1/s)(c - m) = cost of additional committed consumption
• c′ = additional resources devoted to consumption
• c = worker’s consumption
• s = value of committed resources

2. Shadow Price of Traded Goods

• For exports, shadow price = FOB price
• For imports, shadow price = CIF price

3. Shadow Price of Non-traded Goods

Non-traded goods (e.g., land, buildings, local transport services) do not participate in international trade; hence, border prices are not available.

Their shadow prices are determined using marginal social cost (MSC) and marginal social benefit (MSB). L-M recommend breaking down the monetary cost of non-traded goods into:

• Labor (SWR)
• Tradable Social Conversion Factor (SCF)
• Residual components SCF

FAQ's

What is the L-M Approach in Social Cost-Benefit Analysis?

The L-M Approach, developed by I.M.D. Little and J.A. Mirlees, is a method of project appraisal that emphasizes the use of shadow prices to reflect the real social value of resources. It focuses on savings as the yardstick and measures costs/benefits using border (international) prices.

Why are border prices used in the L-M Approach?

Border prices (FOB for exports, CIF for imports) reflect the true social opportunity cost of traded goods in an open economy. They are considered more accurate than domestic market prices in developing countries.

Related Posts

Previous

Next