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

UNIDO Approach

This approach is mainly based on the publication of Organization) named Guide to Practical Project Appraisal in 1978.

The UNIDO approach of Social Cost Benefit Analysis involves five stages:

1. Calculation of financial profitability of the project measured at market prices.
2. Obtaining the net benefit of the project at shadow (efficiency) prices. (Objective of SCBA -1)
3. Adjustment for the impact of the project on Savings & Investment. (Objective of SCBA -2)
4. Adjustment for the impact of the project on Income Distribution. (Objective of SCBA -3)
5. Adjustment for the impact of the project on Merit and Demerit Goods whose social values differ from their economic values. (Objective of SCBA-4)

Stage one – Net Present Value of a Project is calculated as:

Formula:

$$\text{NPV} = \sum_{t=1}^{T} \frac{(V_t - C_t)}{(1 + K)^t} - I_0$$

Where:

• $V_t$ = Value of outputs at market prices in year t

• $C_t$= Value of inputs at market prices in year t

• $K$ = Discount rate

• $T$ = Economic life (lifetime) of the project

• $I_0$ = Initial investment cost incurred at the start of the project

• $t$= Time period (year)

The project is viewed as financially feasible if NPV > 0.

Stage-2: Obtaining the net benefit of the project at economic (shadow) prices

• The Commercial Profitability analysis (calculated in stage 1) would be sufficient only if the Project is operated in perfect market. Because, only in a perfect market, market prices can reflect the social value.
• If the market is imperfect (most of the cases in reality), net benefit of the Project is determined by assigning shadow prices to inputs and outputs.
• Therefore, developing shadow prices is very much vital.

General Principles of Shadow Pricing

1. Numeraire: A unit of account in which the values of inputs and outputs are to be expressed.
• Numeraire is determined at-
• Domestic currency (BDT) rather than border price.
• Present value rather than future value. Because," a bird in the hand is worth two in the bush.”
• Constant price rather than current price.
2. Tradability: Tradability refers to whether a good or service is tradable or non-tradable; if tradable whether is fully traded or non-traded. A good/service is tradable in the absence of or within limited trade barriers. A tradable good/service is actually traded when-
• The import (export) supply is perfectly elastic over the relevant range of volume.
• All additional demand (production) must be made (consumed) by import (export) due to the full capacity in the domestic industry (fulfillment of demand by domestic consumer).
• The import (CIF) price is less or the export (FOB) price is more than the domestic cost of production.
3. A good/service is non-tradable; if
• Its import (CIF) price is greater than its domestic cost of production, and/or
• Its export (FOB) price is less than its domestic cost of production.
• A tradable good/service that is not actually traded is called non traded.
4. Sources of Shadow Pricing: Depending on the impact of the project on national economy, there are three sources of shadow pricing.
• Taxes:
• If the project augments domestic production, taxes should be excluded;
• If the project consumes existing fixed supply of nontraded inputs, tax should be included;
• For fully traded goods, tax should be ignored.
• Consumer Willingness to Pay (CWP):
• What a consumer wants to spend for a product or service.
• The difference between CWP and actual payment is called consumer surplus.
• Externalities: An externality is an external effect (either beneficial or harmful) causes from a project which is
• Not deliberately created by the project sponsors but is an incidental outcome.
• Beyond the control of the persons who are benefited or affected by it. Not traded in the market place.
• Shadow Pricing of Externalities: Although valuation of external effects is difficult as they are often intangible in nature and there is no market price, shadow pricing of externalities may be made indirect means such as:
• The harmful effect of the bridge may be measured by the consumer willingness to pay for the output of the people which has been reduced due to the bridge.
• The cost of pollution may be estimated in terms of the loss of earnings as a result of damage to health caused by it.
• Capital: Investment of capital in a project causes to happen two things:
• Financial resources are converted into physical assets
• Financial resources are withdrawn from national pool of savings.
• Thus, alternative projects are foregone and there is an opportunity cost of it. The shadow price of physical assets is calculated in the same manner in which inputs and outputs are calculated. The opportunity cost of capital (shadow price of capital) depends on the source from which the capital has generated.

Stage – 3: Adjustment for the impact of the project on Savings & Investment

The purposes of this stage are to –determine the amount of income gained or lost because of the project by different income groups (such as project other than business, government, workers, customers etc.) Evaluate the net impact of these gains and losses on savings Measure the adjustment factor for savings and thus the adjusted values for savings impact. Adjust the impact on savings to the net present value calculated in stage two.

Stage – 4: Adjustment for the impact of the project on Income Distribution

Government considers a project as an investment for the redistribution of income in favour of economically weakens sections or economically backward regions. This stage provides a value on the effects of a project on income distribution between rich & poor and among regions.

1. Distribution Adjustment Factor (Weight) is calculated and the impacts of the project on income distribution have been valued by multiplying the adjustment factor with the particular income of a group. This value will then be added to the net present value re-calculated in stage three to produce the social net present value of the project.
2. Determination of Weights: It there are only two groups in a society, poor and rich, the determination of weight is just an iterative process between the analysts (at the bottom) and the planners (at the top). This is called “bottom up” approach.

When more than two groups are involved, weights are calculated by the elasticity of marginal utility of income. The marginal utility of income is the weight attached to an income and is given by:

Formula:

$$w_i = \left(\frac{b}{c_i}\right)^n$$

Where:

• $w_i$ = Weight of income at income level $c_i$

• $c_i$ = Income level of group i

• $b$ = Base (reference) income level that is assigned a weight of 1.0

• $n$ = Elasticity of the marginal utility of income

Stage – 5: Adjustment for Merit and Demerit Goods

If there is no difference between the economic value of inputs and outputs and the social value of those, the UNIDO approach project evaluation ends at stage four.

• In practical, there are some goods (merit goods),
• Social value of which exceed the economic value (e.g. oil, creation of employment etc.) and
• Also, there are some goods (demerits goods),
• Social value of which is less than their economic value (e.g., cigarette, alcohol, high grade cosmetics etc.)

Adjustment to the net present value of stage 4 is required if there is any difference between the social and economic value.

The steps of adjustment procedure are:

• Estimating the present economic value
• Calculating the adjustment factor
• Multiplying the economic value by the adjustment factor to obtain the adjusted value
• Adding or subtracting the adjusted value to or from the net present value of the project as calculated in stage four.

L-M Approach

I.M.D Little & J.A.Mirlees have developed this approach for analysis of Social Cost-Benefit in Manual of Industrial

• Project Analysis in Developing Countries and Project Appraisal & Planning for Developing Countries.
• I.M.D. little and James A. Mirlees have developed an approach to SCBA which is famously known as L-M approach.

The core of this approach is that the social cost of using a resource in developing countries differs widely from the price paid for it. Hence, it requires Shadow Prices to denote the real value of a resource to society. (Mentioned earlier)

Features of L-M Approach

1. L-M Numeraire is present uncommitted social income.
2. An L-M method opts for savings as the yardstick of their entire approach. Present savings is more valuable to them than present consumption since the savings can be converted into investment for future.

L-M approach rejects the ‘consumption’ Numeraire of UNIDO approach since the authors (L & M) feel that the consumption of all level is valuable. This approach measures the cost and benefits in terms of international or border prices.

Why Border prices? 

Because the border prices represent the correct social opportunity costs or benefits of using or producing traded goods.

Social Cost-Benefit Analysis (SCBA)

The resources – inputs & outputs – of a project are classified into mainly: Labor, Traded Goods &Non-traded Goods

Therefore, to find out the real value of these resources, we should calculate –

1. Shadow Wage Rate (SWR) - The purpose of computing the SWR is to determine the opportunity cost of employing an additional worker in the project. For this we have to determine –
• The value of the output foregone due to the use of a unit of labor
• The cost of additional consumption due to the transfer of labor
• L-M suggests the following formula for calculating the SWR: SWR = m + (c'-c) + (1-1/s) (c-m)
• Here,  m = marginal productivity of the wage earner, c'-c = cost of urbanization, (1-1/s) (c-m) = cost of additional committed consumption, c'= additional resources devoted to consumption, c = consumption of wage earner, 1 = value of uncommitted resources,1/s = value of committed resources, c-m = additional consumption of labor, c' (transportation system, e.g. road construction, motor vehicles) – c (e.g. bus rent) = cost of urbanization (e.g. road construction)
2. Shadow price of Traded Goods - Shadow price of traded goods is simply its border or international price.
• If a good is exported, its shadow price is its FOB price;
• If a good is imported, its shadow price is its CIF price.
3. Shadow price of Non-traded Goods - Non-traded goods are those which do not enter into international trade by their very nature. (e.g. land, building, transportation) hence, no border price is observable for them. Ideally, Shadow price of Nontraded Good is defined in terms of marginal social cost (MSC) and marginal social benefit (MSB). L-M suggest that the monetary cost of non-traded goods be broken down into – Labor SWR (Social Wage Rate), Tradable Social Conversion Factor (SCF), Residual components SCF.

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