UNIDO Approach
The UNIDO approach to Social Cost-Benefit Analysis (SCBA) is primarily based on the 1978 publication “Guide to Practical Project Appraisal” by the United Nations Industrial Development Organization (UNIDO). It provides a systematic framework for evaluating projects by considering not only their financial returns but also their broader social and economic impacts.
This approach involves five key stages:
- Calculation of Financial Profitability – Assessing the financial viability of the project using market prices.
- Net Benefit at Shadow Prices – Evaluating the project’s benefits and costs at shadow (efficiency) prices to reflect the true economic value. (Objective of SCBA – 1)
- Impact on Savings and Investment – Adjusting for how the project influences the overall levels of savings and investments in the economy. (Objective of SCBA – 2)
- Impact on Income Distribution – Considering the project’s effect on the distribution of income across different groups in society. (Objective of SCBA – 3)
- Impact on Merit and Demerit Goods – Accounting for goods and services whose social values differ from their market values, such as education (merit good) or tobacco (demerit good). (Objective of SCBA – 4)
The UNIDO approach ensures that project appraisal goes beyond narrow financial profitability and captures the wider developmental, distributive, and social objectives of an economy.
Stage One: Net Present Value (NPV) of a Project
The Net Present Value (NPV) of a project is calculated as:
Where:
- Vt = Value of outputs at market price at time t
- Ct = Value of inputs at market price at time t
- K = Discount rate
- T = Lifetime of the project
- I0 = Initial cost at the start of the project
Interpretation:
A project is considered financially feasible if NPV>0.
Stage 2: Estimating the Net Benefit at Economic (Shadow) Prices
While Stage 1 focuses on financial profitability based on market prices, these prices may not reflect the true social value of resources, especially in the presence of market distortions. Therefore, Stage 2 involves recalculating project net benefits using shadow prices, which aim to capture the real economic value of inputs and outputs.
Why Shadow Pricing Is Necessary
- Financial analysis is valid only in a perfectly competitive market, where prices reflect social opportunity costs.
- In practice, most markets are imperfect, influenced by taxes, subsidies, trade restrictions, or monopolistic behavior.
- Hence, shadow pricing becomes essential to properly evaluate the project's impact on national welfare.
Key Principles of Shadow Pricing
1. Numeraire
The numeraire is the unit of account used to express the value of inputs and outputs in economic terms. It is typically chosen as:
- The domestic currency (e.g., BDT), not border prices.
- In present value terms rather than future value reflecting the principle, “a bird in the hand is worth two in the bush.”
- At constant prices to eliminate inflationary effects and ensure consistency.
2. Tradability of Goods and Services
Tradability determines how inputs and outputs are priced:
- A tradable good/service can be exported or imported when:
- Import/export supply is perfectly elastic over the relevant quantity range.
- The domestic industry operates at full capacity, so increased demand must be met through imports or increased production must be exported.
- The import price (CIF) is lower, or the export price (FOB) is higher, than domestic production cost.
- A non-tradable good/service is one where:
- The CIF price is higher than domestic cost, and/or
- The FOB price is lower than domestic cost.
- A non-traded good/service is one that is technically tradable but not actually traded due to various constraints.
3. Sources of Shadow Pricing
a. Taxes and Subsidies
- Exclude taxes if the project increases domestic production.
- Include taxes if it uses up a fixed supply of non-tradable inputs.
- Ignore taxes for fully traded goods, as border prices already reflect global opportunity costs.
b. Consumer Willingness to Pay (CWP)
- Reflects the maximum amount a consumer is willing to pay for a good or service.
- The difference between CWP and actual payment represents the consumer surplus and can guide shadow price estimation.
c. Externalities
Externalities are unintended side effects (positive or negative) of a project that affect third parties:
- They are not deliberately created and not reflected in market prices.
- Examples:
- Negative: Pollution, congestion, environmental damage.
- Positive: Improved public health, better access to services.
Shadow pricing of externalities is complex due to intangibility, but indirect estimation is possible:
- Measure willingness to pay for lost benefits (e.g., decreased productivity due to a harmful project).
- Estimate health-related costs or productivity losses from environmental degradation.
d. Capital
Investment in capital results in:
- Conversion of financial resources into physical assets.
- Withdrawal of funds from the national savings pool, potentially crowding out other investments.
Thus, capital has an opportunity cost, and its shadow price depends on the source of funding and the potential returns from alternative uses. Shadow pricing for capital follows the same process as for other inputs and outputs.
Stage 3: Adjustment for the Impact on Savings and Investment
This stage evaluates how the project affects national savings and the capacity to invest in other development activities.
Objectives of Stage 3
- Identify income gains or losses due to the project for various stakeholders (e.g., government, workers, customers, business entities).
- Estimate how these income changes affect savings behavior since different groups have different savings propensities.
- Calculate a savings adjustment factor, representing the overall effect of the project on national savings.
- Apply this factor to the net present value (NPV) derived in Stage 2, to adjust for the impact on the investment potential of the economy.
Why This Adjustment Matters
- Projects that direct more income to high-saving groups enhance future investment capacity.
- Projects that benefit low-saving groups may result in higher immediate consumption but lower long-term investment.
- Including this adjustment ensures that the NPV better reflects long-term development implications, beyond immediate economic efficiency.
Stage Four: Adjustment for the Impact of the Project on Income Distribution
At this stage, the project is evaluated for its role in redistributing income between different social groups and regions. Governments often treat projects as instruments for improving equity by channeling benefits toward economically weaker sections or backward regions.
Key steps include:
- Distribution Adjustment Factor (Weight):
- Adjustment factors (weights) are applied to the income of different groups.
- The project’s effect on income distribution is then measured by multiplying these weights with the group incomes.
- This adjusted value is added to the Net Present Value (NPV) (from Stage Three) to compute the Social Net Present Value (SNPV).
- Determination of Weights:
- Case 1: Two Groups (Rich and Poor): Weights are determined through an iterative process between analysts and planners, known as the bottom-up approach.
- Case 2: More than Two Groups: Weights are derived using the concept of the elasticity of marginal utility of income. The marginal utility of income (weight attached to an income group) is expressed as:
Explanation of Terms:
- wi: Weight assigned to the income of group i.
- ci: Income level of group i.
- b: Base income level (typically the income level that receives a weight of 1).
- n: Elasticity of the marginal utility of income.
Context:
This formula is used in Stage 4 of the UNIDO Social Cost-Benefit Analysis (SCBA) approach to calculate distributional weights. It reflects the idea that a unit of income has more value to a poorer person than to a richer one.
- When ci<bi, wi>1, meaning the income of group i (a poorer group) is given greater weight.
- When ci>bi , wi<1, meaning the income of a richer group is down-weighted.
- The higher the value of n, the greater the sensitivity to income inequality.
Stage Five: Adjustment for Merit and Demerit Goods
If there is no difference between the economic value and the social value of inputs and outputs, the UNIDO approach for project appraisal concludes at Stage Four.
However, in reality, certain goods carry different social valuations compared to their economic values.
Types of Goods:
- Merit Goods: Goods whose social value exceeds their economic value, such as oil, education, or employment generation.
- Demerit Goods: Goods whose social value is lower than their economic value, such as cigarettes, alcohol, or luxury cosmetics.
Adjustment Procedure:
When such differences exist, the following steps are carried out:
- Estimate the Present Economic Value of the relevant goods or services.
- Calculate the Adjustment Factor to reflect the difference between social and economic valuations.
- Multiply the Economic Value by the Adjustment Factor to obtain the adjusted value.
- Incorporate the Adjusted Value into the Net Present Value (NPV):
- Add the adjusted value if it is a merit good.
- Subtract the adjusted value if it is a demerit good.
Interpretation:
This stage ensures that project appraisal reflects not just financial and distributive aspects, but also the societal desirability or undesirability of certain goods. By adjusting for merit and demerit goods, the Social Net Present Value (SNPV) of a project provides a more comprehensive measure of its contribution to overall welfare.
FAQ's
Why is the UNIDO approach important?
It helps policymakers and planners assess not only the financial profitability of projects but also their broader impact on equity, income distribution, and social welfare.
What is the role of shadow prices in the UNIDO approach?
Shadow prices correct market distortions (like taxes, subsidies, and price controls) to reflect the true economic value of inputs and outputs.
How does the UNIDO approach address inequality?
In Stage Four, the method applies weights based on marginal utility of income to give higher social value to benefits received by poorer groups, thereby promoting income redistribution.
What is the ultimate goal of the UNIDO approach?
To provide a holistic measure of a project’s worth by combining financial, economic, and social dimensions, ensuring that development projects contribute to both efficiency and equity.
What are merit and demerit goods in this approach?
• Merit goods: Social value > economic value (e.g., education, employment generation). • Demerit goods: Social value < economic value (e.g., tobacco, alcohol).
