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What is Economic Analysis?

What is Economic Analysis? Economic Analysis Key Questions What do we mean by ‘Economic Analysis’? Why
Economic Analysis
Economic Analysis

Key Questions

What do we mean by ‘Economic Analysis’?

Why do we need ‘ Economic Analysis’?

Economic Analysis of a project is to assess the social profit by measuring the effects of the project on the fundamental objectives of the whole economy.

What should be considered in an ‘Economic Analysis’?

Why do we need Economic Analysis?
Why do we need Economic
Analysis?

We adopted Economic Analysis to measure the social profit instead of money profit itself.

Economic Analysis of a project provides the decision-maker to allocate their resources more efficiently and effectively.

What should we consider in an Economic Analysis?
What should we consider
in an Economic Analysis?

Enumeration of Cost and Benefit

Measurement of Cost and Benefit

Thus it is called CBA.

Economic Anal y sis: Cost - Benefit Analysis Cost-Benefit Analysis (CBA) is a set of

Economic Analysis: Cost-Benefit Analysis

Economic Anal y sis: Cost - Benefit Analysis Cost-Benefit Analysis (CBA) is a set of procedures

Cost-Benefit Analysis (CBA) is a set of procedures for defining and comparing benefits and costs.

Decisions are made by decision makers, and benefit-cost analysis is properly regarded as an aid to decision making and not the decision itself (Zerbe/Dively 1994).

Cost and Benefit Analysis
Cost and Benefit Analysis

Cost-Benefit Analysis involves the consideration of Social Benefits and Social Costs, so it is widely used in evaluating and assessing many government projects and decisions.

In CBA, the Willingness to Pay or to Accept as measured by the Compensating and Equivalent Variations is the correct theoretical measures for welfare changes.

Examples of Public Projects: using CBA
Examples of Public
Projects: using CBA

Pricing non-market goods is common.

Community and public goods. where “free riders” cannot be excluded.

Intangible externalities, e.g noise and congestion cost, human lives saved, the pleasure derived by passers-by from flowers and trees in private gardens.

THE CBA Approach
THE CBA Approach

Most basically, list all relevant items

Value expected benefits and costs

Discount the future flow of benefits and costs

Appraise the pro ect by setting off aggregate benefits against aggregate cost

Willingness to Pay and to Accept  Willingness to pay for a good or to

Willingness to Pay and to Accept

Willingness to Pay and to Accept  Willingness to pay for a good or to avoid

Willingness to pay for a good or to avoid cost is subject to the budget.

Willingness to accept payment to forego a good or to bear cost is different from willingness to pay and it could be infinite.

Compensation Variation and Equivalent Variation could be adopted to measure the above two concepts.

could be adopted to measure the above two concepts . Consumer Surplus Consumer Surp us s
Consumer Surplus Consumer Surp us s approx mate y t e amount one wou l
Consumer Surplus
Consumer Surp us s approx mate y t e amount one wou
l
i
i
l
h
ld
pay
f
or t
h
e goo
d

, over what one does pay, rather than do without the good (Zerbe/Dively 1994).

Figure 1

P A CS P0 B D0
P
A
CS
P0
B
D0

Q0

Source : Adapted from Richard O. Zerbe. Jr. and Dwight D. Dively. 1994. Benefit-Cost Analysis In Theory And Practice. New York: Harper Collins College Publishers, pp. 84.

A: Consumer Surplus B: Payment

Producer Surplus Producer Surplus is an amount that can be taken from the producer or
Producer Surplus
Producer Surplus is an amount that can be taken from the producer or
input supplier without diminishing the amount supplied.

Figure 2

P0

S PS Xo
S
PS
Xo

X

Source : Adapted from Richard O. Zerbe. Jr. and Dwight D. Dively. 1994. Benefit-Cost Analysis In Theory And Practice. New York: Harper Collins College Publishers, pp. 88.

Measures of willingness to Pay, Willingness to Accept, Consumer Surplus and Producer Surplus
Measures of willingness to Pay,
Willingness to Accept, Consumer
Surplus and Producer Surplus

Social benefits and costs are important to evaluate a project as well as important to the policy maker as an reference in undertaking public projects.

In evaluating the Willingness to Pay and Willingness to Accept, we can adopt the Compensating and Equivalent Variations for measurement.

Compensated Demand Curves and Compensating Supply Curves for facilitating our assessment.

Compensating Variation Equivalent Variation
Compensating Variation
Equivalent Variation

It gives the maximum (minimum) amount of money that can be taken from (must be given to) a household so as to leave it just well off as it was before a fall (rise) in price.

It provides the minimum (maximum) amount of money that must be given to (taken from) a household to make it as well off as it would have been after a fall (rise) in price.

Summaries of Compensating Variation and Equivalent Variation

Compensating Variation Equivalent Variation Money which can be taken or given to leave one as
Compensating Variation
Equivalent Variation
Money which can be taken
or given to leave one as well
off
as before the economic
Money taken or given that leaves
one as well off as after the
economic change
change
Amount
he/she
would
be
Amount
he/she would be willing
W lf
e
are
w
illi
ng o pay
t
f
or
th
e c ange
h
t
o accep
t
t
o
f
orego
th
e
c
h
ange
Gain
(finite
limited
by
his
(could be infinite)
(benefit)
income)
Amount
he/she
would
be
Amount
he/she would be willing
Welfare
Loss
willing to accept as
compensation for the change
(could be infinite)
to avert the change
(finite – limited by his income)
(cost)

Source: Adapted from R. Layard and A.A. Walters, Microeconomic Theory, Hill: New York, 1978, pp.150-152

McGraw

Expenditure Functions Expenditure Function is commonly adopted as expressions in much of modern welfare theory.
Expenditure Functions
Expenditure Function is commonly adopted as expressions in
much of modern welfare theory.

For a price decrease P 0 > P 1

1

1,

, so that CV > 0

CV = C[P 0 1 , P 0 2 , U 0 )] - C[P 1 1 , P 0 2 , U 0 )]

P Compensation a Variation P1 A CV b P2 D0 H 1 (U 1 )
P
Compensation
a
Variation
P1
A
CV
b
P2
D0
H 1 (U 1 )
H 2 (U 2 )
X4 X3 X2 X1
X4
X3
X2
X1

X

Ex p enditure Functions (Cont’d) For a price change P 0 1 to P 1

Expenditure Functions (Cont’d)

Ex p enditure Functions (Cont’d) For a price change P 0 1 to P 1 1

For a price change P 0 1 to P 1 1, EV = C[P 0 1 , P 0 2 , U 1 )] - C[P 1 1 , P 0 2 , U 1 )]

P a Equivalent C Variation EV b B X D0 H 1 (U 1 )
P
a
Equivalent
C
Variation
EV
b B
X
D0
H 1 (U 1 )
H 2 (U 2 )

P1

A
A

P2

X4

X3

X2

X1

The Rate of Discount Social Time Preference Rate (STP) Adopted when we have to forego
The Rate of Discount
Social Time Preference
Rate (STP)
Adopted when we have to
forego current consumption
presently and obtain the
benefits of the project in the
future.
Social Opportunity Cost
Rate of Interest (SOC)
Applied when we are
estimating the future
consumption foregone by
not taking the alternative
investment.
Risk and Uncertainty
Risk and Uncertainty

Adding premia to the discount rate is a widely adopted principle.

However, not all phenomena exhibit the pattern of ‘riskness’.

A minor technical adjustment make a possible error in estimating individual items.

Economic Analysis for consideration Steps involved
Economic Analysis for
consideration
Steps involved

1. Identify benefits and costs, and quantify

2. Include shadow pricing and opportunity cost, if necessary

3. Apply evaluation methods as in financial appraisal, e.g.

- Discount Cash Flow

- Net Present Value

- Internal Rate of Return

- Benefit-cost ratio

Methods of Economic Analysis (Cont’d) 4. Apply sensitivity and risk analysis Present worth of the

Methods of Economic Analysis (Cont’d)

Methods of Economic Analysis (Cont’d) 4. Apply sensitivity and risk analysis Present worth of the expected

4. Apply sensitivity and risk analysis

Present worth of the expected net social benefit = i=1 PiXi

Where Pi = Possibility of an event,Xi = Expected net social benefit

ty of an event, Xi = E xpecte d net soc ial benefit E xamp le

Example

an event, Xi = E xpecte d net soc ial benefit E xamp le There is

There is an existing old and poor single-two road running between Town A and Town B. There is a proposal to construct a new highway to relieve the increasing traffic on the road. After considering all constraints, a new route has been drawn up for constructing the highway to connect the two towns, crossing a crop field. Identify the social benefits and social costs of the proposed highway project.

Example (Cont’d)
Example (Cont’d)

Social benefits

1. Less fuel used by vehicles

2. Less traveling

3. Reduction of maintenance and repair costs to existing road

4. Fewer injuries to pedestrians

5. Benefits from greater business turnover

Social costs

1. Costs of resources committed

2. Maintenance and repair costs to new highway

3. Loss of crop production

Difficulties with a CBA
Difficulties with a CBA

Allowing for the distributional effects

Adjusting market prices to allow for indirect taxes

Estimating the willingness to payfor intangibles which are market non-priced

Choosing the appropriate discount rate

Providing for risk and uncertainty

Conclusion
Conclusion
Conclusion  Like a private investor, the public sector is also concerned about the financial implication

Like a private investor, the public sector is also concerned about the financial implication of its investments.

Market prices do not fully reflect the true costs and benefits of an investment, largely due to market failure and imperfection.

Such external effects should therefore be dealt with in economic analysis (always economists refer it to as “cost- benefit analysis”.

A financially viable project may not necessarily be economically feasible.