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Should We Treat Cost Benefit Analysis Differently

between Developed and Developing Countries?


Professor Euston Quah
Editor, Singapore Economic Review
Department of Economics
Nanyang Technological University, Singapore

ADBI Seminar Presentation


Tokyo, 13 Oct 2015

The views expressed in this presentation are the views of the


author and do not necessarily reflect the views or policies of
the Asian Development Bank Institute (ADBI), the Asian
Development Bank (ADB), its Board of Directors, or the
governments they represent. ADBI does not guarantee the
accuracy of the data included in this paper and accepts no
responsibility for any consequences of their use. Terminology
used may not necessarily be consistent with ADB official terms.

Introduction
GDP and National Income statistics have grown in importance in informing
policies
These statistics have crucial drawbacks:
Income inequality not taken into account
Problem can be overcome by augmenting National Accounts with
measures of inequality (Gini coefficient)
Costs of growth ignored
Costs are largely non-market in nature
Currently no comprehensive measure to take into account these
costs
Huge outlay involved in compiling such accounts
CBA may be a better tool to account for costs of growth, in
massive or largely impactful public projects

Importance of CBA in Developing


Countries
Cost Benefit Analysis (CBA) is more important to Developing Countries:
Developing countries need to grow faster if convergence with
developed countries is to take place
Much of the worlds natural resources are in developing countries
Greater conservation pressure
Governments in developing countries face tighter budget constraints,
limited funds for both developmental and environmental objectives
Greater need to ensure optimal project choice

Fundamentals of CBA
Fundamentals of CBA for both developed and developing countries are the
same:
CBA must be complete
Valuations must reflect the true social cost/benefit
Time and uncertainty must be taken into account
Double counting must be avoided
Transfer payments should be ignored

Differing Market Conditions


Appropriate CBA techniques may differ depending on differing market
conditions in developing countries:
Differences in
a. Labour market
b. Goods market
c. Financial market
have implications on CBA techniques

a. Labour Market in Developing


Countries
Higher level of disguised employment in agricultural sector
A significant portion of agricultural workers are actually employed in
name only, and paid a token wage despite making no marginal
contribution to the production process
Overstatement of opportunity cost
Higher level of household production and underground economy

More incomplete/inefficient labour market


Wages not reflective of true opportunity costs of labour
Value of Statistical Life (VoSL) calculations based on wage differentials
may be inaccurate

b. Goods Market in Developing


Countries
Less efficient goods market due to larger information asymmetry
Greater distortions by taxes, subsidies, and other forms of government
intervention (e.g. price ceilings, price floors, fuel subsidies)
Distorted values of direct inputs
Incomplete values of externalities and non-market goods if revealed
preference approaches are adopted

May need to use shadow pricing for correction


Tradable goods: greater fluctuations in currency
Difficulty in determining shadow prices

c. Financial Market in Developing


Countries
Under-developed and less perfect financial market
Greater market power of private banks
Higher interest rates due to market power
Presence of oligopolistic banks
Social discount rate based on market interest rate is inappropriate and
biased against environment or long term projects
Time-preference will also differ due to differing lifespan
Social discount rate may be higher

Evaluation of Suitability of
Valuation Techniques
Differing conditions
Differing suitability of valuation techniques
Broad categories of techniques
i.
Revealed preference approaches
ii. Stated preference approaches
iii. Benefit-transfer method
iv. A newer approach: Paired comparison method/damage schedules
approach

i. Revealed Preference Approaches


E.g. Hedonic pricing, travel cost method
Require strong assumptions
Rationality, perfect information, perfect mobility etc.
Assumptions rarely hold in developing countries
Markets are largely incomplete and imperfect
Data insufficiency, distorted data

ii. Stated Preference Approaches


E.g. Contingent Valuation Method (CVM)
Subjected to behavioral bias
Framing effects, status quo bias etc.
Behavioural bias likely to be greater for developing countries where
experience with surveys are limited
Sunk cost effect: People often take some account of their previous
(irretrievable) outlays or commitments when considering future
moves
Subjected to methodological bias
E.g. Confusion between Willingness-To-Pay (WTP) and ability to pay
Bias exacerbated by lack of trained interviewers

ii. Stated Preference Approaches


Example of Behavioral Bias
People value losses much more than gains
Median WTA/WTP = 2.6
Mean WTA/WTP = 7
WTA should be used for most environmental changes: Where there are
losses (of the environment) from a neutral reference (e.g. loss of habitat)
Usual current practice all over the world: Use the lesser amount of what
people would pay to preserve it (WTP)
Systematic understatements of values
Can lead to bad choices that can compromise public welfare and to
economically unwarranted deterioration of the environment

ii. Stated Preference Approaches


Since WTA > WTP
Could still use the WTP measured, adjusting it for the degree of loss
aversion to obtain WTA
Adjustment based on further studies
Across goods: Measuring the difference in loss aversion between
different groups of composite goods (e.g. environmental vs nonenvironmental)
Across rich and poor countries: Measuring the difference in loss
aversion between rich and poor countries
Within country, across income groups: Measuring the difference in
loss aversion between rich and poor within the same country,
controlling for country characteristics

iii. Benefit-Transfer Method


In developing countries, lack of indigenous studies (e.g. VoSL) and poor
data availability hampers good CBA studies
Method: Transfer values from foreign studies to local context
1. Describe policy scenario: Determine characteristics of risks and populations
to be addressed by the target study

2. Identify potentially relevant existing valuation research


3. Review existing studies for quality and applicability: E.g. Similarities of
health effects, similarities of population, ability to adjust for differences in the
two contexts

4. Transfer the estimates: Making any necessary adjustments. Transfer may


be based on the results of a single study or several studies.

5. Address uncertainty: E.g. Conduct sensitivity or probabilistic analysis and


discuss the implications of uncertainty

iii. Benefit-Transfer Method


Less expensive and time consuming than conducting new primary
research
Applying previous research (in one context) to populations with
significantly different income levels (in a dissimilar context) is particularly
challenging.
Depends on good judgment of analyst
Estimates are likely to be less accurate than carefully designed and
implemented study
Cultural differences
Differences in resource endowments and facilities
E.g. Availability of doctors/hospitals affect valuation of health and
life

iv. Paired Comparison Method


(Damage Schedule Approach)
Does not require strong assumptions like revealed preference approaches
Can be combined with CVM to provide monetary valuations
Directly addresses the population and effects of concern, unlike benefittransfer method
Comparisons could be between
Market goods and non-market goods (environmental goods)
Goods and money

iv. Paired Comparison Method


(Damage Schedule Approach)
Method:
1. Participants make discrete binary choice between pairs in a survey
Describe items in as much detail as possible to minimize the need for
respondents imagination
If the number of combinations is not too many, all possible combinations of
binary choices should be shown to every respondent
Obtain preference score: Number of times the item is chosen
1.

Ranking then derived from variance stable rank method


Sum up the preference scores of each item across all respondents in the
sample
Then divide by maximum number of times it could have been selected
Values obtained are the proportion of times the item is preferred, which
allows for measurements of intensity of preferences
Some degree of indifference is allowed since scores of different items may
be the same

iv. Paired Comparison Method


(Damage Schedule Approach)

Source: Q. Ong and E. Quah, Theoretical Economic Letters April 2014

iv. Paired Comparison Method


(Damage Schedule Approach)
Author

Year of Study

Items of Study

Peterson and
Brown

1998

6 public goods (2 environmental, 4 non-environmental)


4 private goods
11 monetary sums

Rutherford et
al.

1998

4 non-pecuniary environmental losses resulting from oil spills

Cheunpagde
et al.

2001

(Part 1) 8 losses of economic resources


(Part 2) 8 increases in economic activity

Quah et al.

2006

(Part 1) 8 losses related to the environment


(Part 2) 10 monetary gains, 4 environmental improvements

Ong et al.

2008

(Part 1) 2 improvements and 2 reductions in losses pertaining to


education
(Part 2) 2 improvements and 2 reductions in losses pertaining to
transportation
(Part 3) 2 improvements and 2 reductions in losses pertaining to
the environment

Evaluation of Suitability of
Valuation Techniques
All valuation techniques have relative advantages and disadvantages
Governments must exercise care in deciding which techniques are most
suitable for their purposes

Differing Severity of CBAs


Limitations
Primary weakness of CBA: Efficiency-oriented
Lack of accounting for equity
Greater problem for developing countries
Greater income inequity in developing countries than in developed
countries
Weights may not be the ideal solution
Technical issue of weight determination
Possibility of manipulation and abuse
Equity implications may have to be considered separately
Further research needed into behavioral biases

Conclusion
Should CBA be used as a decision tool for developing countries?
Definitely, but with three conditions:
1. CBA should only be a guide, not the sole arbiter of projects
2. Care must be exercised to choose appropriate valuation techniques
3. Inequity issues should be considered independently

References: CBA

Cost-Benefit Analysis by E. J. Mishan and Euston Quah;


5th Edition; Routledge 2007 (new 6th Edition forthcoming)

Cost-Benefit Analysis; Cases and Materials by Euston


Quah and Raymond Toh; United Kingdom: Routledge
2012

Cost-Benefit Analysis and the Environment by Nick Hanley


and Clive L. Spash; Edward Elgar 1994

Applied Cost-Benefit Analysis 2nd Edition by Robert J.


Brent; Edward Elgar 2007

Cost-Benefit Analysis; Concepts and Practice 4th edition


by Boardman, Greenberg, Vining and Weimer; Prentice
Hall 2011

Cost Benefit Analysis 2nd Edition edited by Richard Layard


and Stephen Glaister; Cambridge University Press 1994

A Guide to Benefit-Cost Analysis 2nd edition by Edward M.


Gramlich; Waveland Pr Inc 1997

Applied Welfare Economics; Cost-Benefit Analysis of


Projects and Policies by Massimo Florio; Routledge 2014

References: CBA for Developing Countries


The Globalization of Cost-Benefit Analysis in
Environmental Policy
edited by Michael A. Livermore and Richard L. Revesz
Oxford University Press 2013

One of the only books on the market that provides a


discussion of cost-benefit analysis in developing
countries
Offers a cohesive compilation of case-studies that
serve to balance out the theory
Includes the contributions of international scholars
and leading thinkers in the risk field

References: CBA for Developing Countries


Principles of Cost-Benefit Analysis for Developing
Countries
by Caroline Dinwiddy and Francis Teal
Cambridge University Press 1996

combine an introduction to welfare economics, a


discussion of project appraisal principles in developing
countries and a survey of the cost-benefit problems raised
by externalities, risk and the environment. There are
references throughout to contemporary research work in
developing economics, and a number of important
development policy issues, such as trade reform,
commodity price stabilization and the rate of exploitation
of natural resources, are considered within a unified costbenefit framework

References: CBA for Developing Countries


Project Appraisal for Developing Countries
by Robert J. Brent
Edward Elgar 1998