Economic Analysis

10/25/2014 7.
DeterminingEconomicValues
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7.DETERMININGECONOMICVALUES
Oncefinancialpricesorcostsandbenefitshavebeendeterminedandenteredintheprojectaccounts,
theanalystestimatestheeconomicvalueofaproposedprojecttothenationasawhole.Thefinancial
pricesarethestartingpointfortheeconomicanalysistheyareadjustedasneededtoreflectthevalueto
thesocietyasawholeofboththeinputsandoutputsoftheproject.
Whenthemarketpriceofanygoodorserviceischangedtomakeitmorecloselyrepresentthe
opportunitycost(thevalueofagoodorserviceinitsnextbestalternativeuse)tothesociety,thenew
valueassignedbecomesthe"shadowprice"(sometimesreferredtoasan"accountingprice").Inthe
strictestsense,ashadowpriceisanypricethatisnotamarketprice,butthetermusuallyalsocarries
theconnotationthatitisanestimateoftheeconomicvalueofthegoodorserviceinquestion,perhaps
weightedtoreflectincomedistributionandsavingsobjectives.
Inchapter2,forpurposesofprojectanalysis,wetooktheobjectiveofafarmtobetomaximizethefarm
family'sincrementalnetbenefit,theobjectiveofthefirmtomaximizeitsincrementalnetincome,and
theobjectiveofthesocietytomaximizethecontributionaprojectmakestothenationalincomethe
valueofallfinalgoodsandservicesproducedinthecountryduringaparticularperiod.Theseobjectives,
andtheanalysistotesttheirrealization,wereseeninfinancialtermsforfarmsandfirms.Buteconomic
analysisofaprojectmovesbeyondfinancialaccounting.Strictlyspeaking,wemaysaythatinfinancial
analysisournumerairethecommonyardstickofaccountistherealincomechangeoftheentitybeing
analyzedvaluedindomesticmarketpricesandingeneralexpressedindomesticcurrency.Butin
economicanalysis,sincemarketpricesdonotalwaysreflectscarcityvalues,ournumerairebecomesthe
real,netnationalincomechangevaluedinopportunitycost.Aswewillnotebelow,onemethodology
expressestheseeconomicvaluesindomesticcurrencyandusesashadowpriceofforeignexchangethe
shadowpriceincreasesthevalueoftradedgoodstoallowforthepremiumonforeignexchangearising
fromdistortionscausedbytradepolicies.Anothermethodinuseexpressestheopportunitycostvalueof
realnationalincomechangeindomesticcurrencyconvertedfromforeignexchangeattheofficial
exchangerateandappliesaconversionfactortotheopportunitycostorvalueinuseofnontradedgoods
expressedindomesticcurrencytheconversionfactorreducesthevalueofnontradedgoodsrelativeto
tradedgoodstoallowfortheforeignexchangepremium.
Beforea detaileddiscussionofadjustingfinancialaccountstoreflecteconomicvaluescommences,an
importantpracticalconsiderationmustbeemphasized.Manyoftheadjustmentstothefinancialaccounts
canbecomequitecomplex.Noteverypointmadeinthischapterwillapplytoeveryagriculturalproject,
norwillallpointshavethesameimportanceinthoseprojectswheretheydoapply.Thecomplexityof
somecalculationsandtherelativeimportanceofsomeadjustmentsrecallthereasonforundertakingan
economicanalysisofaproject:toimprovetheinvestmentdecision.Someadjustmentswillmakea
considerabledifferencetotheeconomicattractivenessofaproposedprojectotherswillbeofminor
importance,andnoreasonableadjustmentwouldchangetheinvestmentdecision.Whatweneedtodo
hereistoadoptanaccountingpracticethedoctrineofmateriality.Theanalystmustfocushisattention
onthoseadjustmentstothefinancialaccountsthatarelikelytomakeadifferenceintheproject
investmentdecision.Heshoulduseroughapproximationsorignoretrivialadjustmentsthatwillnotmake
anydifferenceinthedecision.Thereisanimportantbalancetobestruckbetweenanalyticalelegance
andgettingonwiththejob.
Inthischapterwewilladjustthefinancialpricesoftangibleitemstoreflecteconomicvaluesinthree
successivesteps:(1)adjustmentfordirecttransferpayments,(2)adjustmentforpricedistortionsin
tradeditems,and(3)adjustmentforpricedistortionsinnontradeditems.Beforeembarkingonthisseries
ofadjustments,wewillexaminetheproblemofdeterminingtheappropriatepremiumforforeign
exchange.Aftercompletingtheadjustments,wewillsummarizethemainpointsina"decisiontree"for
determiningeconomicvalues.
10/25/2014 7.DeterminingEconomicValues
Theseriesofsuccessiveadjustmentstothefinancialaccountswillleadtoasetofeconomicaccountsin
whichallvaluesarestatedin"efficiencyprices,"thatis,inpricesthatreflectrealresourceuseor
consumptionsatisfactionandthatareadjustedtoeliminatedirectandindirecttransfers.Thesevalues
willbemarketpriceswhenmarketpricesaregoodestimatesofeconomicvalueortheywillbeshadow
priceswhenmarketpriceshavehadtobeadjustedfordistortions.Whenweadjustfinancialpricesto
reflecteconomicvaluesbetter,inthevastmajorityofcaseswewillusetheopportunitycostofthegood
orserviceasthecriterion.Wewilluseopportunitycoststovalueallinputsandoutputsthatare
intermediateproductsusedintheproductionofsomeothergoodorservice.Forsomefinalgoodsand
services,however,theconceptofopportunitycostisnotapplicablebecauseitisconsumptionvaluethat
setstheeconomicvalue,notvalueinsomealternativeuse.Intheseinstances,wewilladoptthecriterion
of"willingnesstopay"(alsocalled"valueinuse").Weneedtodothis,however,onlywhenthegoodor
serviceinquestionisnontraded(perhapsasaresultofgovernmentregulation)duringsomepartofthe
lifeoftheprojectapointtowhichwewillreturnlaterinourdiscussion.Becausetheultimateobjective
ofalleconomicactivityistosatisfyconsumptionwants,allopportunitycostsarederivedfrom
consumptionvalues,andthusfromwillingnesstopay.
Anexamplemayclarifyouruseofwillingnesstopayandopportunitycost.Supposeacountrythatisa
ratherinefficientproducerofsugarhasapolicytoforbidsugarimportstoprotectitslocalindustry.The
priceofsugarmaythenrisewellabovewhatitwouldbeifsugarwereimported.Evenatthesehigher
prices,mostconsumerswillstillbuysomesugarfordirectconsumptionsay,incoffeeorteaeven
thoughtheymayuselesssugarthanifthepricewerelower.Thedomesticpriceofsugarwillbeabove
theworldmarketpriceandwillrepresentthevalueofthesugarbythecriterionofwillingnesstopay.If
wewerenowtoconsidertheeconomicvalueofsugarfromthestandpointofitsuseinmakingfruit
preserves,itsvaluewouldbecometheopportunitycostofdivertingthesugarfromdirectconsumption,
wherewillingnesstopayisthecriterionandhassettheeconomicvalue.
Economicanalysis,then,willstatethecostandbenefittothesocietyoftheproposedprojectinvestment
eitherinopportunitycostorinvaluesdeterminedbythewillingnesstopay.Thecostsorvalueswillbe
determinedinpartbyboththeresourceconstraintsandthepolicyconstraintsfacedbytheproject.The
differencebetweenthebenefitandthecosttheincrementalnetbenefitstreamwillbeanaccurate
reflectionoftheproject'sincomegeneratingcapacitythatis,itsnetcontributiontorealnationalincome.
Thesystemoutlinedherewillmakenoadjustmentfortheincomedistributioneffectsofaproposed
projectnorforitseffectontheamountofthebenefitgeneratedthatwillbeinvestedtoacceleratefuture
growth.Rather,theeconomicprojectanalysis,statedinefficiencyprices,willjudgethecapacityofthe
projecttogeneratenationalincome.Theanalystcanthenchoosefromthosealternativeprojects(or
alternativeformulationsofroughlythesameproject)thehighyieldingalternativethatinhissubjective
judgmentalsomakesthemosteffectivecontributiontoobjectivesotherthanmaximizingnational
incomeobjectives
suchasincomedistribution,savingsgenerated,numberofjobsproduced,regionaldevelopment,national
security,orwhatever.Thechoiceaboutthekindofprojectwillofcoursebemaderatherearlyinthe
projectcycle.Thus,itmaybedeterminedearlyonthatforreasonsofsocialpolicyaprojectwillbe
preferredthatencouragessmallholderagricultureratherthanplantations.Then,thechoiceswilllikelybe
severalprojectsorvariantsofprojectsthatencouragesmallholderstheanalyticaltechniquepresented
herecandeterminefromamongtheprojectsthatwillfurtherthedesiredsocialobjectivetheonesthat
aremoreeconomicallyefficient.
Althoughthesystemoutlinedheremakesnoadjustmentforincomedistributioneffectsorforsaving
versusconsumption,itiscompatiblewithotheranalyticalsystemsthatdo.Inparticular,Squireandvan
derTak(1975)recommendevaluatingproposedprojectsfirstbyusingessentiallythesameefficiency
pricesthatwillbeestimatedhereandthenbyfurtheradjustingthesepricestoweightthemforincome
distributioneffectsandforpotentialeffectsonfurtherinvestmentofthebenefitsgenerated.Thesystems
inLittleandMirrlees(1974)andtheuxmoGuidelinesforProjectEvaluation(I972a),withminordepartures,also
proposeevaluatingtheprojectbyfirstestablishingitseconomicaccountsinefficiencypricesandthenby
adjustingtheseaccountstoweightthemforincomedistributionandsavingseffects.Makingallowances
forincomedistributionandsavingseffectsinvolvessomewhatmorecomplexadjustmentsthanthose
necessarytoestimateefficiencypricesitalsounavoidablyincorporatessomeelementofsubjective
judgment.Althoughthesesystemshaveattractedwidespreadinterestamongeconomists,their
applicationhasbeenonlypartialoronalimitedscale.Thesystemofeconomicanalysisusingefficiency
pricesthatisoutlinedhereisessentiallytheonecurrentlyusedforallbutafewWorldBankprojects
andalsotheoneusedformostanalysesofprojectsfundedbyotherinternationalorganizations.
Theeconomicanalysisfollowsonthefinancialanalysispresentedintheprecedingchaptersitwillbe
basedonprojectedfarmbudgetssimilartothoseinchapter4,onprojectedaccountsforcommercialfirms
suchasthoseinchapter5,andonprojectedgovernmentcashflowssuchasthoseinchapter6.Since
theseaccountsareprojectedforthelifeoftheproject,therewillbenoseparateallowancefor
depreciation.Instead,asnotedearlier,thecostswillhavebeenenteredintheyearstheyareincurred
andthereturnsintheyeartheyarerealized.
Intheeconomicanalysis,wewillwanttoworkwithaccountscastonaconstantbasisthuswewill
wanttobesurethatanyinflationcontingencyallowanceshavebeentakenout.Asnotedinchapter2,
however,physicalcontingencyallowancesandcontingencyallowancesintendedtoallowforrelativeprice
changesareproperlyincorporatedintheeconomicaccounts,evenwhentheaccountsareinconstant
prices.Ofcourse,anyoftheitemsincludedamongthecontingenciesmayberevalued,ifnecessary,to
adjustthemfromtheirmarketpricestoeconomicvalues.Theprojectedfinancialaccountswillusually
nothaveanyentryforcash.Instead,theywillshowseparatelythecashpositionofthefarmerornotea
cumulativecashsurplusordeficit.Itispossible,however,thatsomeaccountsmayhaveacashbalance
includedinanentryforworkingcapitalorthelike.Ifsuchanentryexists,itmustberemovedfromthe
economicanalysissincewewillbeworkingonarealbasisintheeconomicaccounts,wewillshow
realcostswhentheyoccurandrealbenefitswhentheyarerealized.
DeterminingthePremiumonForeignExchange
Adjustingthefinancialaccountsofaprojecttoreflecteconomicvaluesinvolvesdeterminingtheproper
premiumtoattachtoforeignexchange.Thatdeterminationquicklyinvolvesissuesofobtainingproper
valuesandofeconomictheory.Fortunatelyformostagriculturalprojectanalysts,theanswertothe
questionabouthowtodeterminetheforeignexchangepremiumissimple(andsimplistic):askthecentral
planningagency.Thepointisthatifvariousalternativeinvestmentopportunitiesopentoanationareto
becompared,thesameforeignexchangepremiummustbeusedintheeconomicanalysisofeach
alternative.Otherwisewewillbemixingapplesandorangesandcannotuseouranalysisreliablyto
chooseamongalternatives.Sometimes,however,theanalystwillbeforcedtomakehisownestimateof
theforeignexchangepremium.Apracticalapproach,alongwithsomeofthetheoreticalandapplied
problemsofthecomputation,isgivenbyWard(1976).LittleandMirrlees(1974),SquireandvanderTak
(1975),andtheUNIDOGuidelines(1972a)alsooutlineinconsiderabledetailhowtomakethe
conversionbetweenforeignexchangeanddomesticcurrencywhentheiranalyticalsystemsareused.
Theneedtodeterminetheforeignexchangepremiumarisesbecauseinmanycountries,asaresultof
nationaltradepolicies(includingtariffsonimportedgoodsandsubsidiesonexports),peoplepaya
premiumontradedgoodsoverwhattheypayfornontradedgoods.Thispremiumisnotadequately
reflectedwhenthepricesoftradedgoodsareconvertedtothedomesticcurrencyequivalentatthe
officialexchangerate.Thepremiumrepresentstheadditionalamountthatusersoftradedgoods,onan
averageandthroughouttheeconomy,arewillingtopaytoobtainonemoreunitoftradedgoods.Sinceall
costsandbenefitsineconomicanalysisarevaluedonthebasisofopportunitycostorwillingnesstopay,
itistherelationbetweenwillingnesstopayfortradedasopposedtonontradedgoodsthatestablishes
theirrelativevalue.
Thepremiumpeoplearewillingtopayfortradedgoods,then,representstheamountthat,onthe
average,tradedgoodsaremispricedinrelationtonontradeditemswhentheofficialexchangerateis
usedtoconvertforeignexchangepricesintodomesticvalues.Byapplyingthepremiumtotradedgoods,
weareabletocomparethevaluesoftradedandnontradedgoodsbythecriterionofopportunitycostor
willingnesstopay.Althoughthispremiumiscommonlyreferredtoastheforeignexchangepremium,it
shouldberecognizedthatthepremiumisactuallyapremiumfortradedgoodsforeignexchangeitself
hasnointrinsicvalue.Thepremiumfortradedgoodsisapremiumontheparticular"basket"oftraded
goodsthatthepresentandprojectedtradepatternimplies.Ofcourse,futurepatternsoftradecould
changetheexactcompositionofthebasket,andthusthepremiumwouldchangetoestimatethese
changesinvolvesaknowledgeofelasticitiesthewaydemandandsupplyofgoodsandservicesvary
whenpriceschangethatisgenerallynotavailable.Wheresuchelasticitiesareknown,itispossiblefor
awelltrainedeconomisttoprovidetheprojectanalystwithamoreaccurateestimateoftheexpected
premiumonforeignexchange.
Iftradeditemsweretobetakenintotheprojectanalysisataneconomicvalueobtainedbysimply
multiplyingtheborderpricebytheofficialexchangeratewithoutadjustingfortheforeignexchange
premium,importeditemswouldappeartoocheapanddomesticitemstoodear.Thiswouldencourage
overinvestmentinprojectsthatuseimports.Forexample,ifcombineharvesterslookcheapbecauseno
allowanceismadeforthepremiumontradedgoods,thenimportedcombinesmightdisplacelocal
harvestlabor,eventhoughthelocallabormighthavenootheropportunitiesforemployment.
Therearetwoequivalentwaysofincorporatingthepremiumonforeignexchangeinoureconomic
analysis.Thefirstistomultiplytheofficialexchangeratebytheforeignexchangepremium,which
yieldsashadowforeignexchangerate.[Notethatthisderivationoftheshadowexchangerateis
appropriateforefficiencyanalysisofprojectsandthushasadiscretedefinition.Otherdefinitionsofthe
shadowexchangerateareappropriatedependingontheusestowhichtheratewillbeput.Bachaand
Taylor(1972)discusssomeofthesealternatives.]Theshadowexchangerateisthenusedtoconvertthe
foreignexchangepriceoftradeditemsintodomesticcurrency.Theeffectofusingtheshadowexchange
rateistomaketradeditemsrelativelymoreexpensiveindomesticcurrencybytheamountoftheforeign
exchangepremium.(Analternativearithmeticformulationistoconverttheforeignexchangepriceinto
domesticcurrencyattheofficialexchangerateandthenmultiplyby1plustheforeignexchange
premiumstatedindecimalterms.)Theshadowexchangerateapproachhasbeenusedinthepastinmost
WorldBankprojectswhenadjustmentshavebeenmadetoallowfortheforeignexchangepremiumon
tradedgoods,anditisalsousedintheUNIDOGuidelines(1972a).
Analternativewaytoallowfortheforeignexchangepremiumontradeditemsthatisincreasingly
comingintouseistoreducethedomesticcurrencyvaluesfornontradeditemsbyanamountsufficientto
reflectthepremium.Thisissometimescalledthe"conversionfactor"approach.Initssimplestform,
basedonstraightforwardefficiencyprices,asingleconversionfactorthe"standardconversionfactor"of
SquireandvanderTakisderivedbytakingtheratioofthevalueofallexportsandimportsatborder
pricestotheirvalueatdomesticprices(SquireandvanderTak1975,p.93).Inthisform,thestandard
conversionfactorbearsacloserelationtoourshadowexchangerateindeed,thestandardconversion
factormaybedeterminedbydividingtheofficialexchangeratebytheshadowexchangerateorby
takingthereciprocalof1plustheforeignexchangepremiumstatedindecimalterms.Marketpricesor
shadowpricesofnontradeditemsarethenmultipliedbythisstandardconversionfactor,andthisreduces
themtotheirappropriateeconomicvalue.LittleandMirrleesandSquireandvanderTakbothadoptthe
conversionfactorapproach.Inaddition,bothpairsofauthorsrecommendderivingspecificconversion
factorsforparticulargroupsofproductsthatwillallowforanydifferencebetweenmarketpricesand
opportunitycostsandfortheforeignexchangepremiumontradeditems.Asaresult,theirspecific
conversionfactorsmayalwaysbeapplieddirectlytodomesticmarketprices.Theseauthorsalso
recommendthattheirconversionfactorsbecalculatedinsocialpricesbyincludingdistributionweights.
Inthevaluationsystemfollowedhere,allitemsarevaluedatefficiencypriceswithoutallowancefor
distributionweights(theissueofselectingprojectstoachievedistributionalobjectivesistreatedasa
subsequentdecision).Thisbeingthecase,considerationofthedistributionweightedconversionfactors
proposedbyLittleandMirrleesandSquireandvanderTakmaybeleftaside,andwemayfocusour
discussionontheSquireandvanderTakstandardconversionfactorasitrelatestoefficiencyprices.
Therelationbetweentheofficialexchangerate(intheequationsbelow,OER),theforeignexchange
premium(Fxpremium),theshadowexchangerate(SER),andthestandardconversionfactor(SCF)isperhaps
easiertounderstandinequationform:
sothat,asSquireandvanderTaknote(1975,p.93),
WemayillustratetheserelationsbyanexampletakenfromtheAgriculturalMinimumPackageProject
inEthiopia.Atthetimetheprojectwasappraised,theanalystknewthattheofficialexchangerateof
Eth$2.07=US$1failedtoaccountforaforeignexchangepremiumofatleast10percent.(Thesymbol
fortheEthiopiandollarisEth$sincethisprojectwasappraisedthenameofthecurrencyunithasbeen
changedtobirr.)Thus,theanalystmultipliedtheofficialexchangerateby1plusa10percentforeign
exchangepremiumtoobtainashadowexchangerateofEth$2.28=US$1(2.07x1.1=2.28)thathe
roundeduptoEth$2.30=US$1.Theshadowexchangeratewasthenappliedtoall'tradeditemsinthe
financialaccounts,therebyincreasingtheirrelativevalue.
Ifthedomesticcurrencyisworthmoreperunitthantheforeignexchange,thearithmeticissomewhat
different.AtthetimetheNucleusEstate/SmallholderOilPalmProjectinRiversState,Nigeria,was
appraised,theofficialexchangeratewasN1=US$1.54.(ThesymbolforNigeriannairaisN.)The
projectanalystsweregivenashadowexchangerateofN1=US$1.27touseintheireconomic
evaluation.If,however,theyhadsimplybeeninformedthattheforeignexchangepremiumwas21
percent,theycouldhavedeterminedtheshadowexchangeratebydividingthedollarvalueby1plusthe
premiumstatedindecimalterms(1.541.21=1.27).
Ofcourse,theeffectofapplyingtheshadowexchangeratetothetradeditemsintheEthiopianproject
wastomakeallnontradeditems10percentlessexpensiveinrelationtothetradeditemsintheeconomic
accountsasopposedtothefinancialaccounts.Now,insteadofincreasingtherelativevalueoftraded
items,wecouldreducethevalueofallnontradeditemsappearinginthefinancialaccountssothatinthe
economicaccounttheyarerelatively10percentlessexpensive.Todothiswecalculatethestandard
conversionfactor,whichis1dividedby1plustheamountoftheforeignexchangepremiumstatedin
decimalterms.Inthiscase,theresultisafactorof0.909(11.1=0.909).Toobtaintheeconomic
values,wewouldthenmultiplyallfinancialpricesfornontradeditemsbythisfactorifthesemarket
priceshavebeenjudgedgoodestimatesofopportunitycostorgoodestimatesofeconomicvalueon
groundsofwillingnesstopay.Fornontradeditemssuchaswageratesforunskilledlaborforwhichitis
feltthatthemarketpricehasoverstatedtheeconomicvalues,wewouldfirstdetermineagoodestimate
oftheeconomicvalueindomesticcurrencyandthenmultiplythatbythestandardconversionfactor.
Financialpricesfortradeditems,whetherimportsorexports,wouldbeleftunchangedintheeconomic
accountsexceptthatanytransferpaymentincludedinthesepriceswouldbetakenout.Togetallvalues
intothesamecurrency,wewouldconvertallforeigncurrencypricestodomesticcurrencyvaluesusing
theofficialexchangerate.
Whenweturntodeterminingmeasuresofprojectworthinchapter9,wewillfindthattheabsolutevalue
ofthenetpresentworthdiffersdependingonwhichapproachweuse,shadowexchangerateor
conversionfactor,butthattherelativenetpresentworthsofdifferentprojectsanalyzedbythesame
approachwillnotchange.Whicheverapproachisused,theinternalrateofreturn,thebenefitcostratio,
andthenetbenefitinvestmentratiodonotchange.(Usinganumberofdisaggregatedconversionfactors,
ratherthanastandardconversionfactor,cangivedifferentvaluesforthemeasuresofprojectworth.
Hence,forprojectsatthemarginofacceptability,usingspecificconversionfactorsratherthana
standardconversionfactororashadowexchangeratemayresultinadifferentdecisiononwhetherto
acceptorreject,butsuchcasesareinfrequent.)
AdjustingFinancialPricestoEconomicValues
Letusnowproceedwiththeadjustmentsnecessarytoconvertfinancialpricestoeconomicvalues.We
willdividetheseintothreesteps:(1)
adjustmentfordirecttransferpayments,(2)adjustmentforpricedistortionsintradeditems,and(3)
adjustmentforpricedistortionsinnontradeditems.Wewillthennotethat,forwhataretermed
"indirectlytraded"items(locallyproduceditemsthatuseahighproportionoftradedinputs,suchas
locallyassembledtractors,orconstructionthatusesimportedmaterials),steps2and3mustbedoneat
thesametime.
Step1.Adjustmentfordirecttransferpayments
Thefirststepinadjustingfinancialpricestoeconomicvaluesistoeliminatedirecttransferpayments.
Directtransferpayments(seechapter2)arepaymentsthatrepresentnottheuseofrealresourcesbut
onlythetransferofclaimstorealresourcesfromonepersoninthesocietytoanother.Inagricultural
projects,themostcommontransferpaymentsaretaxes,directsubsidies,andcredittransactionsthat
includeloans,receipts,repaymentofprincipal,andinterestpayments.Twocredittransactionsthatmight
escapenoticeareaccountspayableandaccountsreceivable.Alltheseentriesshouldbetakenoutbefore
thefinancialaccountsareadjustedtoreflecteconomicvalues.
Manyimportantsubsidiesinagricultureoperatenotbymeansofdirectpaymentsbutthrough
mechanismsthatchangemarketprices.Thesesubsidiesarenotdirectsubsidiestreatedasdirecttransfer
paymentsbutratherareindirectsubsidies.Thefinancialpriceofanitemforwhichthepricehasbeen
changedbecauseofanindirectsubsidyisconvertedtoaneconomicvalueaccordingtotheprocedures
outlinedbelowfortradeditemsinstep2and,asappropriate,fornontradeditemsinstep3.
Step2.Adjustmentforpricedistortionsintradeditems
Thesecondstepinadjustingfinancialpricestoeconomicvaluesistheadjustmentfordistortionsin
marketpricesoftradeditems.
Tradeditemsarethoseforwhich,ifexports,f.o.b.price>domesticcostofproduction,ortheitemsmay
beexportedthroughgovernmentinterventionbyuseofexportsubsidiesandthelike,and,if
imports,domesticcostofproduction>c.i.f.price.
Conceptuallyandusuallyinpractice,toopricesfortradeditemsinprojectanalysisaremoreeasilydealt
withthanthosefornontradeditems.Webeginthevaluationbydeterminingthe"borderprice."For
imports,thisnormallywillbethec.i.f.priceand,forexports,normallythef.o.b.price.Theborderprice
isthenadjustedtoallowfordomestictransportandmarketingcostsbetweenthepointofimportorexport
andtheprojectsitetheresultistheefficiencypricetobeusedintheprojectaccount(seethesubsection
on"Economicexportandimportparityvalues,"below).
Iftheproposedprojectproducessomethingthatcanbeusedinplaceofimportedgoodsthatis,ifit
producesan"importsubstitute"thevaluetothesocietyistheforeignexchangesavedbyusingthe
domesticproductvaluedattheborderprice,inthiscasethec.i.f.price.Butiftheprojectusesitemsthat
mightotherwisehavebeenexportedthatis,ifituses"divertedexports"thentheopportunitycosttothe
societyoftheseitemsistheforeignexchangelostontheexportsforgonevaluedattheborderprice,this
timethef.o.b.price.
Ifweareusingconversionfactorstoallowfortheforeignexchangepremium,theeconomicvalueofa
tradeditemwouldbeobtainedbyconvertingtheforeignexchangepricetoitsdomesticcurrency
equivalentusingtheofficialexchangerate.
Ifweareusingtheshadowexchangeratetoallowfortheforeignexchangepremium,theeconomic
valueofatradeditemwouldbeobtainedbyconvertingtheforeignexchangepricetoitsdomestic
currencyequivalentusingtheshadowexchangerate.
Toillustratehowthesecomputationsaremade,wemaytakeasanexampleanimporteditemsuchasa
combineharvesterforwhichthec.i.f.priceisUS$45,000.Inthefinancialaccounts,wewillconvertthis
pricetodomesticcurrencyusingtheofficialexchangerateof,say,Rs10=US$1,obtainingac.i.f.price
indomesticcurrencyofRs450,000(45,000x10=450,000).Tothiswouldbeaddedanyimportduty,say
10percent,orRs45,000(450,000x0.10=45,000)thepriceofthecombineinourfinancialaccounts
wouldthereforebeRs495,000(450,000+45,000=495,000).(Thecostsofmovingtheharvestertothe
projectsitewouldalsobeaddedseethesubsectionon"Economicexportandimportparityvalues,"
below.)Ifweareusingtheconversionfactorapproachtoallowfortheforeignexchangepremiuminour
economicaccounts,wewouldenterthecombineintheaccountsatthec.i.f.priceexpressedindomestic
currencyconvertedattheofficialexchangerate,orRs450,000(45,000x10=450,000).Therewouldbe
noallowanceforthedutybecausethatisatransferpayment.Ifweareusingtheshadowexchangerate
approachtoallowfortheforeignexchangepremium,however,wewouldincreasethepriceofthe
importeditemstoreflectthepremium.Supposeweassumetheforeignexchangepremiumtobe20
percentourshadowexchangeratethusbecomesRs12=US$1(10x1.2=12).NowtheRs495,000item
inourfinancialaccountsbecomesRs540,000inoureconomicaccount(45,000x12=540,000).We
couldhaveaccomplishedthesamething,ofcourse,bymultiplyingourdomesticfinancialprice(netof
transferpayments)by1plustheforeignexchangepremium(450,000x1.2=540,000).Theeffectofour
computation,obviously,istomakeimporteditemsmoreexpensiveinoureconomicanalysis.
Thesamelogicworksinreverseforexports.Thetonofwheatthatisworth$176atonf.o.b.attheport
ofexportwillbeenteredinthefinancialaccountsbyconvertingtheforeignexchangepricetoits
domesticcurrencyequivalentusingtheofficialexchangerate.ThisgivesavalueofRsl,760(176x10=
1,760),assumingthatthereisnoexportsubsidy.Thesamerupeevaluewouldbeenteredintheeconomic
accountsifweareusingtheconversionfactorapproachtoallowfortheforeignexchangepremium.If
weareusingtheshadowexchangerateapproachtoallowfortheforeignexchangepremium,we
multiplytheforeignexchangeborderpriceofthewheatbytheshadowexchangerateinsteadofthe
officialexchangeratetocalculatetheeconomicvalueexpressedindomesticcurrency.Thisincreases
therelativevalueofthewheat,whichnowwillbevaluedatRs2,112(176x12=2,112).Wecouldhave
accomplishedthesamething,ofcourse,bymultiplyingourfinancialdomesticpriceby1plustheforeign
exchangepremiumstatedindecimalterms(1,760x1.2=2,112).Nowthetonofwheat,likeotherexported
goods,isvaluedatitsopportunitycostandisseentoberelativelymuchmorevaluable.
Divertedexportsandimportsubstitutesarevaluedbythesamelineofreasoning,exceptthatfora
divertedexportwewouldtakethef.o.b.priceasthebasisforvaluationandforimportsubstituteswe
wouldtakethec.i.f.price.Intheexamplesofthepreviousparagraphs,ifthecountryexportedcombines
butdivertedthemtoadomesticproject,theopportunitycostwouldbebasedonthef.o.b.priceinsteadof
thec.i.f.priceweassumedforimportedcombines.Similarly,ifthewheatproducedweretosubstitute
forimports,wewouldbaseitsvalueonthec.i.f.priceofwheatratherthanonthef.o.b.pricewe
assumedforthecaseofexports.
Inpractice,valuesformosttradeditemsaredeterminedbytakingtheborderpriceaswehavebeen
usingitandtheneithersubtractingoraddingthedomestichandlingcoststoobtainaneconomicvalueat
thefarmgateorprojectboundarytheeconomicexportorimportparityvalue(seethesubsectionon
"Economicexportandimportparityvalues,"below).Also,manyitemsthatarelocallyproduced
incorporateasignificantproportionofimportedcomponentsandmaybeconsideredindirectlyimported
items(seethesectionon"IndirectlyTradedItems,"below).Todetermineeitherparityvaluesorvalues
forindirectlytradeditemsinvolvesvaluingseparatelynotonlythetradedcomponentbutthenontraded
componentaswell,sowewilldeferdetaileddiscussionofthesevaluesuntilwehavediscussedvaluing
nontradeditems.
Step3.Adjustmentforpricedistortionsinnontradeditems
Thethirdstepinadjustingfinancialpricestoeconomicvaluesistheadjustmentfordistortionsinmarket
pricesofnontradeditems.Nontradeditemsarethoseforwhichc.i.f.price>domesticcostofproduction
>f.o.b.price,ortheitemsarenontradedbecauseofgovernmentinterventionbymeansofimportbans,
quotas,andthelike.
Often,nontradeditemswillbebulkygoodssuchasstraworbricks,whichbytheirverynaturetendtobe
cheapertoproducedomesticallythantoimportbutforwhichtheexportpriceislowerthanthedomestic
costofproduction.Inotherinstances,nontradeditemsarehighlyperishablegoodssuchasfresh
vegetablesorfluidmilkfordirectconsumption.
Ingeneral,theseareproducedunderrelativelycompetitiveconditionstheyareproducedeitherbymany
smallfarmersorbyafewindustrialproducersforwhomentryintothemarketisrelativelyeasythus
pricescannotrisetoofaroutoflinebeforenewcompetitionappears.
Ifweareusingtheshadowexchangerateapproachtoallowfortheforeignexchangepremium,andif
themarketpriceofanontradeditemisagoodestimateoftheopportunitycost,orwillingnesstopayis
thecriterion,wewillacceptthemarketpricedirectlyasoureconomicvalue.Otherwise,wewilladjust
themarketpricetoeliminatedistortionsbythemethodsoutlinedinthissectionandthenusetheestimate
oftheopportunitycostweobtainastheshadowpricetobeenteredintheeconomicaccounts.
Ifweareusingtheconversionfactorapproachtoallowfortheforeignexchangepremium,anadditional
stepisnecessary.Allpricesfornontradeditemsarereducedbymultiplyingthembytheappropriate
conversionfactor.Whenwillingnesstopayisthecriterionorwhenthemarketpriceisconsideredtobe
agoodestimateofopportunitycost,themarketpriceisacceptedasthebasisforvaluationandthen
reducedbymultiplyingitbytheconversionfactortoobtaintheeconomicvalue.Butifweareusingthe
standardconversionfactorandthemarketpricemustbeadjustedtoobtainabetterestimateofthe
opportunitycost,thentheopportunitycostmust,inturn,bemultipliedbythestandardconversionfactor.
(Ifspecificconversionfactorshavebeendeveloped,asLittleandMirrleesandSquireandvanderTak
suggestintheirsystems,thenthesefactorsincorporatetheadjustmentsfornontradedgoodsdistortions,
opportunitycosts,anddistributionweightsthemarketpriceneedonlybemultipliedbythespecific
conversionfactortoreachtheeconomicvalue.)Whetherweuseashadowexchangerateorastandard
conversionfactortoallowfortheforeignexchangepremium,theadjustmentswemaketoallowfor
distortionsinmarketpricesofnontradeditemsareessentiallythesameonlythestepofmultiplyingthe
marketpriceortheopportunitycostbythestandardconversionfactordiffers.
Aswesaidearlierinthechapter,pricesfortradeditemsaremoreeasilyadjustedtoeconomicvalues
thanarepricesfornontradeditems.Thefollowingsubsectionstreatsomeofthedifficultiesencountered
indeterminingeconomicvaluesforvariousnontradeditems.
Marketpricesasestimatesofeconomicvalue..Inaperfectlycompetitivemarket,theopportunitycostof
anitemwouldbeitsprice,andthispricewouldalsobeequaltothemarginalvalueproductoftheitem
(seechapter3).Ifanontradeditemisboughtandsoldinarelativelycompetitivemarket,themarket
priceisthemeasureofthewillingnesstopayandisgenerallythebestestimateofanopportunitycost.
Mostagriculturalprojectsareexpectedtomeetagrowingdemandforfoodorfiberandaresmall
relativetothetotalagriculturalproductionofthenation.Ifthatisthecase,ingeneralwecanacceptthe
marketpricedirectlyasourestimateoftheeconomicvalueofanontradeditem.Also,ifwearevaluing
adomesticallyproducedprojectinputthatisproducedbyasupplyindustryoperatingnearfullcapacity,
wecangenerallyacceptthemarketpriceoftheinputasitseconomicvalue.
Insomeinstancesmorecommoninindustrialandtransportprojectsthaninagricultural,theoutputofthe
projectislargerelativetothemarket.Theoutputfromtheprojectmaythereforecausethepricetofall.
Buttheeconomicvalueofthenewproduction,despitethefallinprice,isnotlowertotheoldusersof
theproducttothem,itisstillworthwhatthepricewaswithouttheproject.Yettonewusers,theproject
outputisnotworthwhattheoldpricewasotherwise,thepricewouldnothavefallen.Underthese
circumstances,theeconomicvalueofthenewoutputisneithertheoldpricenorthenewrather,itis
estimatedbysomeweightedaverageoftheoldandnewvalues.Intechnicaleconomicterms,thetotal
valueofthenewoutputismeasuredbytheadditionalareaunderthedemandcurveasprojectoutputis
increased,andthemarginalvalueinuseforeachnewbuyerismeasuredbythedemandcurveatthe
pointthebuyerentersthemarket.Theproblemisthatthepreciseshapeofthedemandcurveisrarely
known.Asaresultmostprojecteconomists,whendealingwithaprojectwhoseoutputislargerelative
tothemarket,adoptasimplifyingruleofthumbtheyassumethatthedemandcurveislinearand
downwardslopingat45degrees.Theythentakethenewestimateoftheaveragevalueinuseor
opportunitycosthence,ofeconomicvaluetobetheaverageofthepricewithouttheprojectandthe
lowerpricewiththeproject.
Sometimesaprojectwillbeproposedthatdoesnotmeetnewdemandbutreplacesothergoodsor
servicesinthemarket.Again,thisismorecommoninindustrialandtransportprojectsthanitisin
agricultural.Insuchsituations,iftheprojectaccountsarecastonawithandwithoutbasis,the
economicvalueoftheincrementalnetbenefitstreamwouldreflectonlythesavingfromthenewproject
comparedwiththeold.Thisisbecauseoneofthecostsofthenewprojectwouldbethebenefitforgone
fromtheoldproductionnolongerrealizedandbecauseoneofthebenefitswouldbethecostavoidedfor
theoldproduction.Suchacasemightarise,forinstance,ifaninefficientfoodprocessingplantwereto
bereplacedbyamoremodernandefficientone,orifahighcostrailwaybranchlineweretobe
replacedbybusandtrucktransportalonganexistinghighway.Occasionally,however,aprojectwillbe
proposedforanewplantthatwillreplaceexistingoutput,andtheanalystfailstorecognizethewith
andwithoutsituation.Instead,hevaluestheoutputfromthenewplantasifitweremeetingnewdemand
andforgetstochargeasacosttotheprojectthebenefitforgonefromtheproductionoftheoldplantthat
istobedisplaced.Iftheprojectisnottobecastonawithandwithoutbasis,thentheanalystmusttake
ashisgrossbenefitonlytheeconomicvalueoftheresourcessavedbyreplacingtheoldplant,notthe
economicvalueoftheoutputfromthenewplant.
Notethatsomenontradeditemsmayinvolveusingsignificantamountsofimportedrawmaterials.These
willbeconsideredbelow,inthediscussionofindirectlytradeditems.Suchitemsmightinclude
machineryassembleddomesticallyfromimportedcomponentsorelectricitythatisgenerallynontraded
butthatmayrequireimportedgeneratingequipmentandtradedfuelsforproduction.
Onenontradeditemthatcansometimesleadtoconfusionisinsurance.Atfirstglance,insurancemight
looklikeatransferpaymentandthuswouldnotbeincludedintheeconomicaccountsoftheproject.We
may,however,lookuponinsuranceasakindofsharingoftheriskofrealeconomicloss.Thiswouldbe
thecaseforfireinsuranceifprojectbuildingsweretobepooledwithmanyotherbuildingsinthe
society.Intheeventofafire,thereisarealeconomiccost.Theresourcesusedtoreplaceaburned
building,ortheoutputforgonebecauseabuildingnolongerisavailable,reducetheamountoffinal
goodsandservicesavailabletothesocietyandthuscreatearealreductionofthenationalincome.
Therefore,totheextentaninsurancecostrepresentssharingofrisk,itrepresentsaproportionatesharing
ofrealeconomiccostandshouldbeincludedintheeconomicaccounts.Theinsurancerateisusually
basedontheprobabilityofareallossandthevalueoftheiteminsured.
Althoughthemarketpricecanfrequentlybeacceptedasagoodestimateoftheeconomicvalueofa
nontradeditem,forinstitutionalreasonsofonekindoranotherthemarketpricecanvarysignificantly
fromtheopportunitycostoftheitemtothesociety.Twosuchnontradeditemsareimportantinmost
agriculturalprojects:landandlabor.
ValuingLand.Theopportunitycostoflandisthenetvalueofproductionforgonewhentheuseofthe
landischangedfromitswithoutprojectusetoitswithprojectuse.
Thesimplestcasetovalueisoneinwhichlandchangesusebutnotmanagementcontrol,eitherbecause
anowneroperatorisfarmingthelandorbecausethesametenantcontinuestofarmit.Thisisacommon
caseinagriculturalprojectsinwhichfarmersaresimplyencouragedtoadoptamoreproductive
technology.Iftheanalysthaslaidoutthefinancialaccountstoshowthesituationswithandwithoutthe
projectforfarmbudgetsassuggestedinchapter4,thentheincrementalnetbenefit(thatis,the
incrementalcashflow)oftheproject,whenfinancialpriceshavebeenconvertedtoeconomicvalues
andtheaccountsaggregatedassuggestedinchapter8,willincludeanallowanceforthenetvalueof
productionforgonebychangingthelanduse.Take,forexample,theKemubuIrrigationProjectin
Malaysiainwhichnewirrigationwaterpermittedchangingthelanduseinthedryseasonfromrather
unproductivepasturetosecondcroppaddyriceproduction.Thecontributionofthelandtothevalueof
thepasturehence,itsopportunitycostwouldbeproperlyaccountedforwhenthevalueoftheweight
gainofthelivestockpasturedonthelandwithouttheprojectissubtractedfromthevalueofthepaddy
riceproducedonthelandwiththeproject.Convertingprojectfinancialpricestoeconomicvaluessay,
changingthemarketpriceoftheweightgainoftheanimalsonthepastureandthemarketpriceofpaddy
ricetotheireconomicequivalentsiftheseareseentobedifferentfromthemarketpricesautomatically
revaluestheopportunitycostofthechangeinlandusefromfinancialtoeconomicterms.
Inotherinstances,however,thefinancialaccountsmustshowacostforpurchasinglandortherightto
useit.Hereproblemsarisebecauseinmanycountriesagriculturallandishardlysoldatall,and,whenit
is,considerationsofinvestmentsecurityandprestigemaypushitspricewellabovewhatthelandcould
reasonablybeexpectedtocontributetoagriculturalproduction.Intheseinstances,wewillnotwantto
acceptthemarketpurchasepriceasagoodestimateoftheeconomicopportunitycostofthelandand
mustsearchforanalternative.Manytimesthatalternativewillbetotaketherentalvalueoftheland.In
anumberofcountries,althoughlandisinfrequentlysold,thereisafairlywidespreadandcompetitive
rentalmarket.Thismaybetrueifthereisconsiderabletenancyinthecountry,ofcourse,butitmayalso
holdtrueifthedominantformoflandtenureistheowneroccupiedfarm.Olderfarmersmaynotwishto
cultivatealloftheirholdingsthemselvesandwillbewillingtorentafieldtoayoungerneighboring
farmerwidowsmaynotwishtooperatetheirholdingsthemselvesorafarmersufferingfromanillness
maywishtorentpartofhisfarmforaseasonwhileherecovers.Whensucharentalmarketexists,it
probablyprovidesafairlygoodindicationofthenetvalueofproductionofthelandand,hence,ofthe
opportunitycostifthelanduseischanged.Arenterisnotlikelytopayanypremiumforprestigeor
investmentsecurityandthuswillnotpayarenthigherthanthecontributionthelandcanmaketothe
cropheproposestogrow.Thatrentalvaluemaythenbeenteredintheproject'sfinancialaccountyear
byyearasacost.Alternatively,itmaybecapitalizedbydividingtherentbyanappropriaterateof
intereststatedindecimaltermsthecapitalizedvalueisthenenteredinthefirstyearoftheproject's
financialaccounts.Theappropriaterateofinterestactuallywouldbetheeconomicrateofreturn(see
chapter9),butthismaywellinvolverepetitivecomputations.Someanalystsprefertousetheopportunity
costofcapital(alsodiscussedinchapter9).Ifthisratewere,say,12percentandthegoingrentalrate
wereRs525ahectare,thenthecapitalvalueofahectarewouldbeRs4,375(5250.12=4,375).Ifwe
wereusingtheconversionfactorapproachtoallowfortheforeignexchangepremium,thiscapitalized
valuewouldbe,inturn,multipliedbyaconversionfactor.Ifthestandardconversionfactorwere0.909,
forinstance,thelandwouldthenhaveaneconomicvalueofRs3,977(4,375x0.909=3,977).Attheend
oftheproject,thesamevalueofthelandcouldbecreditedtotheprojectasaresidualvalue.
Inevitably,however,therewillbeinstancesinwhichneitherthepurchasepricenortherentalvalueisa
goodestimatewethenwillhavetomakeadirectestimateoftheproductivecapabilityoftheland.Such
adirectestimateisnotdifficultifidlelandistobeusedforasettlementproject.Intheprojectsfinanced
bytheWorldBankintheAmazonbasinatAltoBeneinBrazilandintheCaquetaregionofColombia,
thelandwithouttheprojectwouldineffecthaveproducednoeconomicallyvaluableoutputatall.
Hence,thenetvalueofproductionforgonewasclearlyzero,andnovalueforthelandwasenteredin
theprojecteconomicaccounts.Ifsettlerswererequiredtopaythegovernmentapurchaseprice,either
allatonceorininstallments,thefarmbudgetsatmarketpricesinthefinancialanalysiswouldhaveto
showthosepaymentsasacost.Whenthesefinancialfarmbudgetswereconvertedtoeconomicvalues,
however,therewouldbenocostenteredforthelandbecausetherewasnoreductioninnationalincome
asaresultofshiftingitsusefromjungletofarmland.(Ofcourse,thecostofclearingjunglelandshould
bereflectedsomewhereintheprojectcosts.)
Inothercasesitwillnotbesosimple.Theanalystwillhavetomakeadirectestimateofthenetvalueof
productionforgoneforbringingthelandintotheproject.Astraightforwardapproachistotakethegross
valueoftheland'soutputatmarketpricesanddeductfromthatallthecostsofproductionincluding
allowancesforhiredandfamilylaborandfortheinterestonthecapitalengaged,againallatmarket
prices.Theanalystcanassigntheresidualasthecontributionofthelandtotheproductionoftheoutput
andtakethatastheopportunitycostofthelandinfinancialterms.Thissetofcomputationscanthenbe
convertedtoeconomictermsbyusingeconomicvaluesforeachoftheinputandoutputentries.Forthose
familiarwiththetechnique,estimatingaproductionfunctionwouldprovideamuchmoreaccurate
estimateofthecontributionofthelandtothevalueoftheoutputthanthedirectmethoddescribedhere
andthusisapreferableapproach.
ValuingLabor.Wageratesforlaborinmanydevelopingcountriesmaynotaccuratelyreflectthe
opportunitycostofshiftinglaborfromitswithoutprojectoccupationtoitswithprojectuse.
Thepriceoflaborinaperfectlycompetitivemarket,likeotherpricesinthatimpossibleplace,wouldbe
determinedbyitsmarginalvalueproduct.Thatis,thewagewouldbeequaltothevalueoftheadditional
productthatoneadditionallaborercouldproduce.Itwouldpayafarmertohireanadditionallaborerfor
harvesting,forexamplesolongasthatextraworkerincreasedtotaloutputbyavaluemorethanthe
wagethefarmerhadtopayhim.
Eveninlaborabundantsocieties,thereareprobablypeakseasonsatplantingandharvestingwhenmost
ruralworkerscanfindemployment.Atthoseseasons,themarketwagepaidrurallaborisprobablya
prettygoodestimateofitsopportunitycostanditsmarginalvalueproducttherefore,wecouldacceptthe
marketwageastheeconomicvalueoftherurallabor.
Theproblemofcourseisthat,exceptforthepeakseasons,inmanycrowdedcountriestheadditionof
onemorelaborermayaddverylittletothetotalproductioninanextremeinstance,nothingatall.That
is,ifthereisasurplusofagriculturalworkers,theremaybeverylittleorvirtuallynoproductiveoutlet
fortheirenergiesintheoffseason.Intechnicallanguage,wemaysaythatthemarginalvalueproductof
suchlabortheamountsuchlaboraddstothenationalincomeisveryclosetozero.Becausethemarginal
valueproductoflaborisalsotheopportunitycostoflaborintheeconomicaccounts,wemaymake
anotherstatement:ifwetakealaborerawayfromafarmcommunitywhereheis
producingverylittleornothingandputhimtoworkproductivelyinanagriculturalprojectthatproduces
somethingofvalue,wedonothavetoforgoverymuchtousethislabortorealizenewproduction.This
beingthecase,wecanconsiderthecostofthelaborertobeverylowsomeeconomistswouldsayeven
zero.Bythislineofreasoning,thepropervaluetoenterintheeconomic(notfinancial)accountasthe
costoflaborwouldbeverysmall,perhapsonlyafractionofthegoingmarketwage.Iftheopportunity
costoflaborinanagriculturalprojectisproperlypricedataverysmallamount,thenitislikelythatthe
rateofreturnontheprojectwilllookveryfavorableincomparison,say,withacapitalintensive
alternativeprojectthatuseslaborsavingtractorsorexpensiveimportedharvestingmachinery.
Notethatthevalidityofthisreasoningisnotchangedbythefactthatagriculturallaboris,infact,paida
wagewellaboveitsopportunitycost.Acommonexampleofa"wage"paid,eventhoughlittleproductive
workisavailableonthemargin,isfoundinthecaseoffamilylabor.Olderchildrenandthefarmer's
wifewillbeentitledtoashareofthefamilyincomeevenifthefamilyfarmistoosmalltogivetheman
opportunitytobeproductive.Inthisinstance,ifanoldersonweretofindproductiveemployment
elsewhere,thetotalproductiononthefarmmightbereducedbyverylittleornoneatall.Yet,because
theoldersonisentitledtoashareofthetotalfamilyincome,hewouldacceptnewemploymentfaraway
fromhishomeonlyifhewereofferedawageinexcessofhisshareandthatmightbewellabovewhat
hismarginalvalueproductwouldbeandthereductioninfarmoutputthatwouldoccurifhewereto
leave.
Ruralwagesmaybeabovethemarginalvalueproductbecauseofatraditionalconceptofa"proper"
wageorbecauseofsocialpressureonthemoreprosperousfarmersinacommunitytosharetheirwealth
withtheirlessfortunateneighbors.InpartsofJava,forexample,socialcustompreventsevenquite
smallfarmersfromharvestingtheirownrice.Instead,theypermitlandlesslaborerstodothework,even
thoughthefarmerhimselfmaywellhavethetimetodoit.Thisisexplicitlyseenbythecommunityasa
meansofprovidingatleastsomethingforthepoorestagriculturallaborers.Unfortunately,increasing
economicpressuresonsmallfarmersandcontinuedpopulationgrowthareleadingtoabreakdownof
thissystem.
Virtuallyalleconomistsnowagreethatthemarginalvalueproductofagriculturallaboronanannual
basisworldwideismorethanzero,sothatineveryinstanceouropportunitycostoflabor,atleastin
someseasonoranother,willbepositiveeventhoughitmaystillbeverylow.[Amoredetailed
discussionofthemarginalvalueproductofagriculturallaborcanbefoundinMcDiarmid(1977)andin
BarnumandSquire(1979).]
Tobeginourdiscussionofhowactuallytodetermineaneconomicvalueforlabor,wecantakethe
easiestcase.Inmostinstances,skilledlaborindevelopingcountriesisconsideredtobeinrathershort
supplyandwouldmostlikelybefullyemployedevenwithouttheprojectbeingconsidered.Hence,the
wagespaidworkerssuchasmechanics,foremen,orprojectmanagersareingeneralassumedto
representthetruemarginalvalueproductoftheseworkers,andthewagesareenteredattheirmarket
valuesintheeconomicaccounts.Therationalehereisthat,ifthoseskillsareinsuchscarcesupplythat
theywouldbeworthmorethanthegoingwage,thensomeoneinthesocietywouldbepreparedtopay
more,andtheskilledworkerwouldthenmovetowherehecouldearnthathigherwage,thusestablishing
anewequilibrium.Thisconventionofacceptingmarketwagesasgoodestimatesofeconomicvaluemay
substantiallyundervalueskilledlabororthemanagementskillsofsuchtopcivilservantsasextension
specialistsandprojectmanagersorprojectanalysts!
Notetoothat,asweconsidertheopportunitycostoflaborandhowtoestimateit,ifwesetthefinancial
accountssotheycorrectlyshowthesituationswithandwithouttheproject,thentheopportunitycostof
familylaborwillbeappropriatelypricedinfinancialterms.Supposethat,inthedryseasonwithoutthe
project,afarmeralongthenorthcoastofJavacouldfindessentiallynogainfulemployment.Withthe
adventoftheJatiluhurIrrigationProjecthenowisabletoproduceasecondcropofrice,andhisnet
benefitrisesaccordingly.Whenwesubtracthiswithoutprojectnetbenefit(whichwouldbeessentially
onlywhatthefamilycouldearnforarainyseasonricecrop)fromthewithprojectnetbenefit(which
willincludeearningsfromtwocrops),theincrementalnetbenefitwillcorrectlyshowthelaborreturn
thefamilyhadtogiveupduringthedryseason(essentiallynothing)toparticipateintheprojectand
produceasecondcropofrice.Shiftingthefinancialpricesinthefarmbudgettoeconomicvaluesalso
automaticallyconvertstheopportunitycostoffamilylabortoeconomicvalues.
Tomakeourfarmbudgetsworkthisway,wemustremembertoincludeanyofffarmearningsinthe
accounts.SupposeweassumethatthefarmerfromthenorthcoastofJavagoestoJakartaandfinds
employmentintheconstructionindustryduringthedryseason,asmanysuchfarmersdo.Thewithout
projectnetbenefitwillthusbeincreasedbytheamountofthefarmer'sofffarmearnings.Ifhewishesto
useJatiluhurirrigationwatertoproduceasecondcropofrice,hemustnowgiveuptheconstruction
wageshecouldotherwisehaveearnedinthedryseason.Inturn,whenwesubtractthewithoutproject
netbenefitfromthewithprojectnetbenefit,whichincludesthereturnsfromtwocropsofrice,the
incrementalnetbenefitwillbesmallerbytheamountoftheopportunitycostoflaboratthemarket
wage,thatis,bytheamountofconstructionearningsthefarmermustforgo.Wemayproceedtoconvert
thesefinancialaccountstoeconomictermsbyrevaluingtheappropriateentriesattheirshadowprices.
Indoingso,however,wemustrememberthatoneshadowpricewillbetheshadowwagerateforthe
constructionearningsthefarmerhadtoforgo.Itistoestimatingthisshadowwageratethatwenowmay
turn.
Inmostdiscussionsofthemarginalvalueproductoflaborhence,ofitseconomicopportunitycostthe
standardistheproductivityofthemarginalagriculturallaborer.Thisistruenotonlyforagricultural
projectsbutalsoforprojectsinothersectors,sinceitisassumedthatadditionalmanufacturing
employment,forexample,willtendtoreducethenumberofunemployedagriculturallaborers.This
wouldbetrueevenifitisurbanworkersdrawnfromsomeotherurbanoccupationwhoactuallytakethe
newfactoryjobs,sinceitisassumedthejobstheyvacatewill,inturn,befilledbyworkersdrawnfrom
agriculture.
Castinthisform,ourestimateoftheshadowwageratemustnowfocusonhowtoestimatethemarginal
valueproductofagriculturallaborwithouttheproject.Wecanbeginbynotingthatinmostagricultural
communitiesthereisusuallyaseasonwhenvirtuallyeveryonewhowantsworkcanfindit.Even
unemployedurbanlaborersmayreturntotheirhomevillagesinthesepeakseasonstohelptheirfamilies
ortoworkashiredlaborers.ThishappensatharvesttimeinJava,andmayhappenatthepeakplanting
timeinotherareaswheretransplantedriceisgrown.Thus,wemayreasonablyassumethatthispeak
seasonlabormarketisarelativelycompetitiveone,thatlaborisinrelativelyshortsupplyatthisperiod,
andthatthedailywageatthisperiodisagoodindicatorofthedailymarginalvalueproductofthelabor
engaged.
Withthisaccepted,agoodestimateoftheannualshadowwageforagriculturallaboristhenumberof
daysintheyearwhenmostrurallaborcanexpecttofindemployment,multipliedbythedailywagerate
atsuchtimes,andreducedbyaconversionfactorifappropriate.Ifanagriculturalworker'sdailywage
atharvestwereRs7.50,andduringharvestandotherpeakseasonsmostpeopleintheruralworkforce
couldfindemploymentfor90days,thenhisannualshadowwagemightbeRs675ifweareusingthe
shadowexchangerateapproachtoallowfortheforeignexchangepremium(7.50x90=675),orRs614
ifweareusingtheconversionfactorapproachandthefactoris0.909(7.50x90x0.909=614).Nowif
wewantedtohireanagriculturallaborertoworkinourprojectfor250daysayear,allthesocietywould
giveupinproductiontheopportunitycostwouldbeRs675ifweareusingtheshadowexchangerate
approach,orRs614ifweareusingtheconversionfactorapproach.Thisopportunitycostistheeconomic
valueoftheannualearningsofthelaborerwithouttheproject.Notethatwesurelywouldhavetoexpect
topayawagemuchgreaterthanthisamount,andthusourfinancialaccountsatmarketpriceswould
havequiteadifferentcostforthissameagriculturallaborer.Itispossible,forinstance,thatthehired
laborerwouldexpectawageofRs7.50adayforall250daysheworkedduringtheyear,oranannual
wageofRs1,875(7.50x250=1,875).Moreprobably,hewouldbewillingtoworkforratherlessaday
outsidetheharvestseasonsay,Rs5.00aday.Thus,hisannualwagemightbesomethingmoreonthe
orderofRs675for90daysandRs5.00adayfortheremaining160days,oranannualtotalwageofRs
1,475[(7.50x90)+(5.00x160)=1,475].Theprojectanalystwouldclearlyhavetoformajudgmentof
theshadowwageofhiredlaboronthebestbasishecould,justashemustforeveryotherpriceestimate
hemakes.
Ofcourse,inmanyagriculturalprojectslaborisnotengagedonayearroundbasis.Rather,theworkis
quiteseasonal,andwemustconsiderinwhichparticularseasonhiredlaborwouldbeengaged.Ifour
new
croppingpatterncallsforworktobedoneduringthepeakseason,thenwewillhavetoconsiderthatthe
peakseasonmarketwageisprobablyagoodestimateofthemarginalvalueproduct,andwecouldnot
justifyusingalowerwageasthebasisforourshadowwagerate,eventhoughtheremightbe
considerableunemploymentintheoffseason.InEgypt,forexample,acommonrotationcallsforboth
riceandcottontobeharvestedinOctober.Ifweweretoproposeaprojectincorporatingthesecropsor
anothercroprequiringhiredlaboratthisperiodthenthegoingwage(in1975aboutE^0.30adaythe
symbolforEgyptianpoundsisE^)wouldbepaid.SinceeveninacountryaspopulousasEgyptmost
rurallaborcanfindemploymentatthispeakseason,theuseofashadowwageratederivedfromabasis
lessthanthemarketwagewouldbeunjustified.Butsupposeourprojectcalledforgrowingmaize,which
isplantedinMaywhenthereislittleotheragriculturalworkavailableandharvestedinAugustbefore
thepeakharvestseasonforriceandcotton.Thenwemightfindthat,onthemargin,manyagricultural
laborerswereeitherunemployedornotveryproductivelyengagedatthatseasonandthattodrawthem
intomaizeplantingmightentailanopportunitycostconsiderablylessthanthegoingwage,althoughit
wouldperhapsnotbezero.Thus,wemightestimatethatatthisseasonthecombinationofbeingableto
workonlytwoorthreedaysaweekontheaverage,andthenatjobsofratherlowproductivity,would
justifytakingashadowwageratebasedonhalfthegoingmarketrate.Thiswouldmeantheequivalent
ofE^0.15in1975ifweareusingtheshadowforeignexchangerateapproach(0.302=0.15),orE^0.14
ifweareusingtheconversionfactorapproachandtheconversionfactoris0.909(0.302x0.909=
0.14),eventhoughourfarmbudgetatmarketpriceswouldcontinuetoshowawageforhiredlaborof
E^0.30.
Alloftheseconsiderationswillhavetobeadaptedtofitthecircumstancesofanygivenproject.For
example,inIndianationwidewemightexpectashadowwagerateforagriculturallaborratherlessthan
thegoingwagerate.Butusinganationwideshadowwagerateinparticularprojectsmightunderestimate
thetrueopportunitycostofthelaboractuallyengagedinaproject.ThepeakseasoninthePunjab,for
instance,findsvirtuallyallagriculturallaborfullyengaged,butintheneighboringstateofHaryanathe
marginallaborinagricultureisnotfullyengaged.WhilemanylaborersfromHaryanadomigratein
searchofpeakseasonemploymentinthePunjab,notenoughdosotomeetthedemandforlabor
completely.UsingaverylowshadowwagerateforaprojectinthePunjabmightbeunjustifiedbecause
atthepeakseasontheprojectwouldhavetobidlaborawayfromharvesting.Thus,althoughtheshadow
wageratemightnotbeashighastheharvestwage(butitmight),neitherwoulditbeaslowas
conditionsinneighboringHaryanamightotherwiseindicate.
Thisdiscussionofhowtovaluelaborapplieswhetherlaboristobepaidamoneywageoristobe
compensatedinkind.Thediscussionsofarhasemphasizedthatitistheopportunitycostthatdetermines
thevalueoflaborinthesystemofeconomicanalysiswehaveadopted.Thevalueof
thepaymentactuallymadetolaborwhetherinmoneyorinkindisnottheissue.Ifweshadowprice
labor,wealreadyareacknowledgingthatthewagethelaborreceivesisdifferentfromthebenefit
forgonebyusingthatlaborintheprojectinsteadofinitsnextbestalternativeusewithouttheproject.It
istheopportunitycostofthelabor,nottheformofpayment,thatsetstheeconomicvalueoflabor.
Hence,itisirrelevantinadeterminationoftheeconomicvalueoflaborwhetherlaborispaidamoney
wageoriscompensatedinkindforexample,infoodgrain,eventhoughthefoodgrainmaybeatradable
commodityandeventhoughthefoodgrainitselfmightneedtobeshadowpricedifitistobevalued.
ExcessCapacity.Insomeprojects,adomesticallyproducedinputmaycomefromaplantthatisnot
operatingatitsfullcapacity.Ifthatisthecase,thentheopportunitycostofusingtheinputinanew
projectisonlythemarginalvariablecostofproducingtheinput,andnoallowanceneedbemadeforthe
fixedcapitalcostoftheplantitself.Ifthenationalcementindustryisoperatingatlessthanitsfull
capacityanditisproposedtolineirrigationcanalswithcement,thenthecostofthecementforthe
canalswouldbeonlythemarginalvariablecostofproducingthecement.Thiswouldbelessthanthe
averagecostofcementproduction,whichwouldincludesomeallowanceforfixedcostsofproduction.
Situationssuchasthesearemorecommoninindustrialprojectsthaninagriculturalprojects.Whenthey
dooccur,however,theymayinfluencethetimingofprojects.Acanalliningprojectmightbequite
attractiveifitisbegunsoon,whilethereisexcesscementmanufacturingcapacity,butmuchless
attractivelater,whendemandhascaughtupwiththecementindustry'scapacity.Tosupplycementfor
canallininglater,afterdemandhaspickedup,wouldentailconstructinganadditionalcementplant.At
thattime,newfixedaswellasvariablecostswouldbeincurred,andtheanalystwouldincludeallcosts,
bothfixedandvariable,plusanestimateofthe"normal"profitincalculatingthecostofcement.
TRADABLEBUTNONTRADEDITEMS.Inthesystemofprojectanalysispresentedhere,welayouttheeconomic
accountsasbestwecantoreflecttherealresourcecostsandbenefitsoftheproposedproject.The
projectwillbecarriedoutwithinaframeworkofeconomicpoliciessetbythegovernment.Theproject
analystmustmakethebestjudgmentaboutwhatthosepoliciesareandwillbe,notjustwhattheyought
tobe,andworktheeconomicanalysisaccordingly.Thiscanleadtodifficultchoiceswhentheanalyst
mustevaluatetherealeffectsonresourcesofaprojectthatinvolvesitemsthatcouldbetradedbut
probablywillnotbebecauseofgovernmentregulation.Theseitems,whichare"tradablebutnontraded"
acrossnationalboundaries,arevaluedasnontraded.
Suchitemswouldusuallybeimportedwereitnotforanimportquota.00 oranoutrightbanthatis
enforcedagainstthem.Theirdomesticpricemaywellrisehighabovetheprevailingpriceontheworld
market.Theimportrestrictionmightbeenforcedtoprotectdomesticindustries,even
thoughtheimporteditemmaybepreferredbyconsumers.Importofforeignenginesfortubewells,for
example,maybeforbiddensothatdomesticmanufacturemightbeencouraged.Yet,thedomestic
equivalentmaynotbeasefficientorasdurableastheimportedengineandmaycostmoretoproduce.
Thedomesticengineclearlycouldnotcompeteontheworldmarket,anditwouldthereforebea
nontradeditem.Forthosefewimportedenginesallowedtoenterthecountry,thepricemayrisequite
high.Thisindicatesthattosomebuyertheimporteditemisworthmorethanitsdomesticequivalent.If
ourprojectwilluseoneoftheseengines,theeconomicvalueisnotapricebasedontheworldmarketas
iftheenginescouldberelativelyfreelytraded.Rather,itisthehigherdomesticmarketpriceofthe
importedengine,whichindicatesitshighopportunitycost.Uponreexamination,ofcourse,wemight
considerchangingtheprojectdesigntousethedomesticengineforexample,wemightdosoifwefind
thedomesticenginetobelesscostlywhenvaluedatshadowprices.
Forthedomesticequivalentofanimporteditem,themarketpriceusuallywillcloselyapproximatethe
realresourceusethatwentintoproducingit.Butifthereisashortageandthepriceisbidup,inthe
absenceofadditionalimportsthemarketpricewillriseabovethecostofproduction.Inthiscase,the
opportunitycostoftheitemwillnotbedeterminedbytheresourcesusedtoproduceitbutbyitsmarginal
valueproductinitsbestalternativeuse.Ifthepriceishigherthanisjustifiedbytheresourcesusedto
producetheitem,itmaywellbebecausetosomeonethathighpriceforthedomesticengineisworthitfor
thisbuyer'spurposes,themarginalvalueproductofthescarceengineatleastequalsthemarketprice.If
wewishtobidthatengineawayforuseinourproject,wearedenyingitsusetotheotherpotential
buyer.Ifweusetheengineinourproject,theeconomymustforgotheproductivecontributionofthe
engineinthealternativeusetheotherpotentialbuyerhadinmindourstandardconceptofopportunity
cost.Again,inthisinstancetheopportunitycostismostlikelywellestimatedbythemarketpriceifit
werenot,otherbuyerswouldnothavebidthepriceupsohighforthelimitednumberofengines
available.
Ifthereisanimportbanonanimportedfinalgoodorservice,thenwewillbasetheeconomicvaluation
onthecriterionofwillingnesstopayandacceptthemarketpriceasagoodindicatoroftheeconomic
valueoftheproductprovidedthatweexpectthetradebantoremaininforcethroughoutthelifeofthe
project.Earlierwecitedtheexampleofabanonsugarimportsthatwouldforcethedomesticpriceof
sugaraboveitsborderprice.Ifthebanonimportswillcontinue,thenthehigherpriceofsugarindicates
awillingnesstopaythat,inturn,isanindicatoroftheeconomicvaluesetonsugarbytheconsumers.In
theprojectanalysis,wewouldacceptthismarketpriceastheeconomicvalue,notaborderpriceasif
thesugarwerebeingtraded.
Forbothkindsofimportsubstituteswehavecited,theanalystmaywanttoprepareananalysisthatwill
indicatetheeffectontheproposedprojectofliftingtheimportban.Wewilldiscussthistopicfurther
below,
andvalueeachseparately.Takelocallyassembledtractors,forexample.Wemaybetoldthatthe
marketpriceofRs65,000includesa30percentlocalcomponent(inotherwords,30percentofthe
marketpricerepresentsdomesticvalueadded)andthat70percentofthemarketpricerepresentsthe
importedcomponent,whichincludesa15percenttariff.Thus,thelocalcomponentwillamountto
Rs19,500(65,000x0.3=19,500),andtheimportedcomponentincludingthetariffwillamountto
Rs45,500(65,000x0.7=45,500).Thedomesticvalueaddedwillmostlikelyarisefromsourcessuchas
wagespaiddomesticskilledlaboranddomesticallymanufactureditemsthatusemainlydomesticraw
materials.Ifso,weprobablycanacceptthemarketpriceasagoodindicatoroftheopportunitycostto
theeconomyoftheseitems.
Todeterminetheeconomicvalueoftheimportedcomponentofthetractor,thetariffmustfirstbe
eliminated.Thismaybedonebydividingthevalueoftheimportedcomponentincludingthetariffby1
plusthepercentageofthetariffstatedindecimaltermsthiscalculationgivesavaluefortheimported
componentwithoutthetariffofRs39,565(45,500
1.15=39,565).Thisis,ofcourse,thec.i.f.priceconvertedtoitsdomesticequivalentattheofficial
exchangerate.
Now,ifweareusingtheshadowexchangeratetoallowfortheforeignexchangepremium,wewill
wanttorevaluetheimportedcomponentoftheindirectimport(afterthetariffhasbeeneliminated)to
reflectthedistortioninthepricesoftradedgoods.Todothis,wecantakethec.i.f.priceconvertedat
theofficialexchangerateandmultiplyitby1plustheforeignexchangepremiumstatedindecimal
terms.IftheofficialexchangerateisRs10=US$1andtheforeignexchangepremiumis20percent,
thenfortheimportedcomponentofthetractorwederiveavalueofRs47,478(39,565x1.2=47,478).
(Wecould,ofcourse,havetakenthec.i.f.priceinforeignexchangeandconvertedittoitsdomestic
equivalentbytheshadowexchangeratethiswouldhavegiventheidenticalresult.)Theshadowpriceof
thetractorisnowthemarketpriceofthedomesticcomponent,whichwecalculatedtobeRs19,500,plus
theshadowpricedvalueoftheimportedcomponentofRs47,478oratotaleconomicvalueofRs66,978
(19,500+47,478=66,978).
Ifweareusingtheconversionfactortoallowfortheforeignexchangepremium,theeconomicvalueof
theimportedcomponentwillbethec.i.f.priceconvertedtothedomesticcurrencyequivalentatthe
officialexchangerateaftereliminatingthetariff,orRs39,565.Toobtaintheeconomicvalueofthe
domesticcomponentwewillneedtomultiplyitbytheconversionfactor.Forefficiencyprices,we
wouldusethestandardconversionfactorof1dividedby1plustheforeignexchangepremiumstatedin
decimalterms.Inthisinstance,theforeignexchangepremiumis20percent,sothestandardconversion
factorbecomes0.833(11.2=0.833).Applyingthistothedomesticcomponentofthetractor,estimated
tobeRs19,500atmarketprices,givesusaneconomicvalueofRs16,244(19,500x0.833=16,244).The
shadowpriceofthetractornowbecomesthesumoftheimportedcomponentvaluedatc.i.f.convertedat
the
officialexchangerateandtheshadowpriceforthedomesticcomponent,orRs55,809(39,565+16,244)
=55,809).
Insomeagriculturalprojects,electricityisanimportantcostthatmayraisevaluationproblems.
Electricityisusuallythoughtofasanontradedcommodity.Inreality,partofthevalueofelectricityin
mostdevelopingcountriesarisesfromtheimportedgeneratingandtransmissionequipmentand,perhaps,
fromimportedfuel.Thus,inoursystemofprojectanalysis,electricitymightbeanindirectlytradeditem.
Thefirstdifficultyisthatthepricechargedforelectricityisnotcompetitivelyset,sincethereisno
competitioninelectricity.Rather,electricityratesareadministeredprices,andelectricitypricesthus
maybearlittlerelationtomarginalvalueproductortoopportunitycost.Noeasymeansexiststoresolve
thisproblem.Someaveragerate,orperhapssomeweightedaveragerate,willprobablyhavetosuffice
asanestimateofopportunitycostatmarketprices.Oncearateisaccepted,anestimatewillhavetobe
madeofthedomesticandimportedcomponents,andthecomponentsrevaluedusingtheshadow
exchangerateoraconversionfactorasappropriate,justasforanyotherindirectlyimporteditem(andas
weillustratedearlierbytheexampleoftractorsassembledfromimportedcomponents).These
calculationswouldusuallynotbeundertakenbyagriculturalprojectanalysts.Theplanningofficeshould
estimateashadowpriceforelectricityandotherutilitiestobeusedinallprojectanalyses.
Forsomeagriculturalprojects,newgeneratingfacilitieswillberequired.Inthesimplestcase,wemight
thinkofaprojectremotefromtheelectricgrid,suchasasettlementproject,inwhichadieselgenerating
unitmightbeincludedasacostoftheproject.Inthatinstance,therewouldbenoparticularproblemof
valuation.Whennewgeneratingfacilitieswouldbeneededtomeetthedemandonthepowergridarising
fromanirrigationproject,however,theproblemwouldnotbesosimple.Here,thebestapproachwould
probablybetoasktheelectricityauthorityforanestimateoftheadditionalcosttheauthoritywouldincur
forthisparticularproject,andthentotreatthatcostproperlyshadowpricedtoallowfortheimported
componentastheopportunitycost.Thecostoftheadditionalfacilitiesneededfortheprojectwill
probablyhavetobereducedtoakilowatthourbasis(using,perhaps,thecapitalrecoveryfactorto
estimatetheannualchargeforthenewfacilities).
Wehavecontrasteduseofashadowexchangerateandaconversionfactortocorrectforprice
distortionscausedbyimportandexporttariffsandsubsidies,andwehavenotedthatthesamecorrection
canberealizedwhicheverapproachisused.Thisisillustratedintable71,inwhichaneconomic
accountforahypotheticalprojectisdrawnupusingbothashadowexchangerateandastandard
conversionfactor.
Whenindirectlytradeditemswillbeusedrepeatedlyinprojects,itmaybeconvenienttohavespecific
conversionfactorsthat,oncetheyarederived,canbedirectlyappliedtothesameclassofindirectly
tradeditems.ThisistheapproachbothLittleandMirrlees(1974)andSquire
Table71.UseofShadowExchangeRateandStandardConversionFactorCompared
Economicvalue(Rs)
b
Item Rs Financial valuesUS$ Usingshadowexchangerate` Usingstandardconversionfactor d Remarks
Inflow
Gross
valueof
wheat

Traded
item
produced 1,750 175 2,100 1,750
Total 1,750 175 2,100 1,750
Outflow
Unskilled
labor

Nontraded
(shadow
wagerate

item
=50%
market
wage)
600 60 300 250
Imported
fertilizer
200

20

240

200

Traded
item
Tractor
services

Indirectly
75%
imported

traded
item
component 90 9 108 90
25%
domestic

120

12

138

115

component 30 3 30 25
Total 920 92 678 565
Netbenefit 830 83 1,422 1,185
Ratioof
inflowto

outflow 1.90 1.90 3.10 3.10
RsIndianrupees.US$U.S.dollars.
a.TheofficialexchangerateisassumedtobeRs10=US$1.Financialpricesareconvertedbythisofficial
exchangerate.
b.Theforeignexchangepremiumisassumedtobe20percent.Asinnotea,theofficialexchangerateisassumedto
beRs10=US$1.
c.TheshadowexchangerateistheofficialexchangerateofRs10multipliedby1plusthepercentageofthe
foreignexchangepremiumstatedindecimalterms,orRs12(10x1.2=12),sothatRs12=US$1.Foreign
exchangeprices
areconvertedintodomesticcurrencyvaluesbymultiplyingtheforeigncurrencypricebyRs12.
d.Thestandardconversionfactoristhereciprocalof1plustheforeignexchangepremiumstatedindecimalterms,
or0.833(11.2=0.833).Foreigncurrencypricesareconvertedintodecimalcurrencyvaluesattheofficial
exchangerate.Domesticcurrencypricesaremultipliedbythestandardconversionfactorof0.833.
andvanderTak(1975)suggest,andbothsetsofauthorsrecommendthatsomecentralagencypreparespecific
conversionfactorsforprojectanalyststouse.Itispossibleinaparallelmannertoderive"specificshadow
exchangerates"thatmaythenbeappliedrepeatedly,althoughinpracticethishasrarelybeendone.Instead,when
theshadowexchangerateapproachisfollowed,nontradeditemsaredecomposedintotheirtradedandnontraded
elementsandeachisvaluedseparately.Useofaspecificconversionfactorcanbeillustratedbyreferringtotable7
1.Supposeweplannedanumberofprojectsinwhichtractorserviceswouldbeimportantandwewantedaspecific
conversionfactorfortractorservices.Oncewehadtheconversionfactorinhand,wecouldmultiplythedomestic
marketpriceofitemsineachprojectbythesamespecificconversionfactortoobtainthevariouseconomicvalues.
Intable71,inthecolumnillustratinguseofthestandardconversionfactor,wehaveavaluefortheimported
componentofthetractorservicesofRs90,whichwasconvertedattheofficialexchangerate.Thedomestic
componentwasmultipliedbythestandardconversionfactortoobtainaneconomicvalueofRs25.Ifweacceptthis
asagoodestimateofthevalueofthedomesticcomponent,thenbyaddingthetwowereachaneconomicvaluefor
thetractorservicesofRsl15.Ifwedividethiseconomicvaluebythedomesticprice,weobtainaspecific
conversionfactorof0.958(115120=0.958).Inthefuture,wecansimplymultiplythemarketpriceoftractor
servicesbythespecificconversionfactortoobtaintheeconomicvaluedirectly.
Economicexportandimportparityvalues
Theeconomicvalueofatradeditemeitheranexportoranimportatthefarmgateorprojectboundaryisitsexport
orimportparityvalue.Thesevaluesarederivedbyadjustingthec.i.f.(cost,insurance,andfreight)orf.o.b.(freeon
board)prices(convertedtoeconomicvalues)byalltherelevantcharges(againconvertedtoeconomicvalues)
betweenthefarmgateorprojectboundaryandthepointwherethec.i.f.orf.o.b.priceisquoted.Thegeneral
methodofcalculatingexportandimportparitypriceswasdiscussedinthelastsectionofchapter3.Whenthese
financialpricesareadjustedtoderivetheireconomicequivalent,bothtradedandnontradedelementsmustbe
valuedsimultaneously.
Themethodsforderivingimportandexportparityvaluesareparallel.Thus,itisunnecessarytodiscussthemethod
forbothinstead,wewilldiscussonlyderivationoftheimportparitypriceasanexamplebecauseimportparity
valuestendtobeabitmorecomplicatedtoderive.
Wemayreturntotheexampleoftheimportedcombineharvesterusedearlierinthechaptertoillustrateeconomic
valuationofatradeditem.Inourfinancialaccounts,thec.i.f.priceofUS$45,000wasconvertedtoitsdomestic
currencyequivalentattheofficialexchangerateofRs10=US$1,towhichwewouldadd,say,a10percentduty,
Rs1,500indomestichandlingandmarketingcharges,andRs2,250ininternaltransportcoststotheprojectsitefor
animportparitypriceatthefarm
gateofRs498,750[(45,000x10)+(45,000x10x0.10)+1,500+2,250=498,750].
Toobtaintheeconomicimportparityvalueatthefarmgateorprojectboundarywhenusingtheshadowexchange
ratetoallowfortheforeignexchangepremium,wewouldmakethesamecomputationsexceptthatwewoulduse
theshadowexchangerateandomitthetariff,whichisatransferpayment.Intheillustrationofvaluingtraded
items,weassumedthattheforeignexchangepremiumontheimportedcombinewas20percent,andsoweassumed
ashadowexchangerateofRs12=US$1(10x1.2=12).Now,toobtaintheimportparityvalueoftheharvester,
wewouldconvertthec.i.f.pricetoitsdomesticequivalentusingtheshadowexchangerate,omitthetariff,and
thenaddthevalueofthenontradeddomesticitems.Tosimplifymatters,wewillassumethatallcostsofmoving
thecombinetotheprojectsitereflectonlynontradeditemsalthoughthatmightnotbeacceptableif,say,the
transportcostsincludedsignificantamountsofpetroleumfuel.Wenowreachaneconomicimportparityvalueof
Rs543,750[(45,000x12)+1,500+2,250=543,7501.
Ifweareusingtheconversionfactortoallowfortheforeignexchangepremium,theforeignexchangewouldbe
convertedtoitsdomesticcurrencyequivalentintheeconomicaccountsbyusingtheofficialexchangerate,and
everynontradeditemwouldbereducedbytheconversionfactor.Recallingthatthestandardconversionfactoris1
dividedby1plustheforeignexchangepremiumstatedindecimalterms,weobtainastandardconversionfactorof
0.833(11.2=0.833).Now,toobtaintheeconomicimportparityvalueoftheharvesteratthefarmgateorproject
boundary,weconvertallforeignexchangecoststodomesticcurrencyattheofficialexchangerateandreduceall
pricesofnontradeditemsbyapplyingthestandardconversionfactor.Again,wewillassumethatthetransport
costsarepredominantlymadeupofnontradeditems.Asbefore,wewillomitthetariffbecauseitisatransfer
payment.TheeconomicimportparitypricethusbecomesRs453,124[(45,000x10)+(1,500x0.833)+(2,250x
0.833)=453,124].
Incertaininstances,thevalueinlocalcurrencyofanimporteditemattheprojectsitewillbeknown,aswillthe
rateoftariffandlocaltransportchargesfromthepointofimporttotheprojectsite.Ifthisisthecase,todetermine
theeconomicvalueitisnecessarytodeterminethec.i.f.price,takeoutthetariff,andallowforthecostofdomestic
transport.Usingourpreviousvalues,wemayknow,forexample,thatacombineharvesterdeliveredtotheproject
sitecostsRs498,750,thatthetariffonimportedharvestersis10percent,andthatlocaltransportanddomestic
handlingfromthepointofimporttotheprojectsitecostsRs3,750.WeknowthattheofficialexchangerateisRs10
=US$1andthattheforeignexchangepremiumis20percent,sotheshadowexchangeratewouldbeRs12=US$1
(10x1.2=12)andthestandardconversionfactor0.833(11.2=0.833).Wedeductthecostoflocaltransportto
obtainafinancialvalueofRs495,000atthepointofentry,whichincludesthec.i.f.priceplustheduty(498,750
3,750=495,000).Totakeouttheduty,wedivideby1plusthepercentageofthedutystatedindecimaltermsto
obtain
Rs450,000(495,0001.1=450,000).Thisisthec.i.f.valueattheofficialexchangerate.Wecanthendividebythe
officialexchangeratetoobtainthec.i.f.valueinforeignexchangeofUS$45,000(450,00010=45,000).Ifweare
usingtheshadowexchangeratetoallowfortheforeignexchangepremium,wecanobtainourc.i.f.economic
valuebymultiplyingbytheshadowexchangerateofRs12=US$1toobtainavalueofRs540,000(45,000x12=
540,000).Then,toobtaintheeconomicvalueattheprojectsite,wewouldaddthecostoftransportfromthepoint
ofentrytotheprojectsitethisyieldsaneconomicimportparityvaluefortheharvesteratthefarmgateorproject
boundaryofRs543,750(540,000+3,750=543,750).Ifweareusingtheconversionfactortoallowfortheforeign
exchangepremium,theeconomicvalueofthecombineattheportwillbethec.i.f.foreignexchangeprice
convertedattheofficialexchangerate,orRs450,000(45,000x10=450,000).Toobtaintheeconomicimport
parityvalueatthefarmgateorprojectboundary,wewouldaddtothisc.i.f.valuethecostofdomestictransport
anddomestichandling,reducedbythestandardconversionfactor,toobtainaneconomicimportparityvalueof
Rs453,124[450,000+(3,750x0.833)_453,124].
Itisclearthattoderivetheimportandexportparityvaluesintheeconomicanalysiswemustomittransfer
payments,allowfortheforeignexchangepremium,anduseshadowpricesforthosedomesticgoodsandservices
forwhichpricesareinaccurateindicatorsofopportunitycost.ThesameexamplesfromtheSudaneseandNigerian
projectsusedtoillustratethediscussionofimportandexportparitypricesinchapter3(tables33and34)areused
againintables72and73toshoweconomicparityvaluesusingboththeshadowexchangerateandthe
conversionfactortoallowfortheforeignexchangepremium.
TradePolicySignalsfromProjectAnalysis
Uptothispoint,wehavebeendiscussingananalyticalsystemthatestimatesthecontributionofaproposedproject
tonationalincomewithinapolicyframeworkthattheprojectanalystconsiderswillexistduringthelifeofthe
project.Wehaveassumedthattheprojectanalysthasverylittleinfluenceontradepolicies,forthisistrueinthe
agriculturesectorinmostcountries.Questionsoftenarise,however,abouttheeffectsonaproposedprojectiftrade
policiesweretochange,andaboutwhetherchangesintradepoliciesshouldberecommended.Unfortunately,
whenassessingtheeffectsonaprojectofpoliciesthatwouldliftorimposeabanontrade,theanalyticalissues
becomeverycomplex,andtheanalysisofasingleprojectisoflimitedusefulness.Thelimitationsofproject
analysisininfluencingpolicyarisefromthepartialnatureofprojectanalysisandfromtheassumptionthatthe
projectinvestmentdoesnotsignificantlychangepricerelationsintheeconomyasawhole.
Twoimportantcasesinvolvingtradepolicyoftenarisethatcausesoulsearchingamongprojectanalysts.Thefirst
iswhenaquotaorprohibitivetariffpreventsentryofacrucialinputperhapsfertilizer
Table72.EconomicExportParityValueofCotton,RahadIrrigationProject,Sudan(1980forecastprices)
StepsinthecalculationCAIat
pointofentry
RelevantstepsintheSudaneseexampleUsingshadowexchangeC.i.f.Liverpool
takenasestimateforall
Lintrate
Valueper
tonSeed
Europeanports) US$639.33 US$103.39
Deductunloadingat
pointofimport Freightand
Deduct freightto

39.63 24.73
pointofimport insurance
Deductinsurance
Equalsf.o.b.atpoint
ofexport F.o.b.PortSudan US$599.70 US$78.66
Convertforeigncurrency Convertedatshadow
todomesticcurrency exchangerateof
atshadowexchangerate ^Sd1.000=US$2.61lb ^Sd229.682 ^Sd30.126
Deductlocalport Porthandlingcost
charges Lint:^Sd5.564perton 5.564
Seed:^Sd1.510perton 1.510
Deduct localtransport FreighttoPortSudan

andmarketing at^Sd6.782perton 6.782 6.782
costsfromprojectto
pointofexport(ifnot
partofprojectcost)

Equalsexportparity Exportparityvalue
valueatproject atginatproject
boundary site ^Sd217.336 ^Sd21.834
Scartoa
Conversionallowance Converttoseedcotton 86.934 12.882 1.102
ifnecessary (^Sd217.336x0.4
+^Sd21.834x0.59 ^Sd100.918
+^Sd110.200x0.01)
Deductlocalstorage, Ginning,baling,and

transport,and storage(^Sd15.229
marketingcosts(ifnot perton) 15.229
partofprojectcost)
Collectionandinternal
transfer(^Sd1.064
perton) 1.064

valueatfarmgate atfarmgate ^Sd84.625
Usingconversionfactors

C.i.f.atpointofentry C.i.f.Liverpool(takenas
estimateforall
Europeanports) US$639.33 US$103.39

Deductunloadingat

pointofimport Freightand
Deductfreightto

39.63 24.73

pointofimport insurance
Deductinsurance

Equalsf.o.b.atpoint

ofexport F.o.b.PortSudan US$599.70 US$78.66
Convertforeigncurrency Convertedatofficial

todomesticcurrency exchangerateof
atofficialexchange ^Sd1.000=US$2.8726 ^Sc1208.809 ^Sd27.389
rate
(Tablecontinuesonthefollowingpages.)
Table72(continued)
Stepsinthecalculation RelevantstepsintheSudaneseexample ValueLint pertonSeed Scartoa
Convertnontradedgoods Convertedusing
toequivalentdomestic standardconversion
valueusingconversion
factorof0.909
6

factors
Deductlocalport Porthandlingcost
charges Lint:^Sd5.564perton 5.058
Seed:^Sd1.510perton 1.373
Deductlocaltransport FreighttoPortSudan
andmarketing at^Sd6.782perton 6.165 6.165
costsfromprojectto
pointofexport(ifnot
partofprojectcost)

valueatproject atginatproject
boundary site ^Sd197.586 ^Sd19.851
Conversionallowance Converttoseedcotton 79.034 11.712 1.002
ifnecessary (^Sd197.586x0.4 I I
+^Sd19.851x0.59
+^Sd110.200x0.909 ^Sd91.748
Deduct localstorage, Ginning,baling,and

transport,and storage(^Sd15.229
marketingcosts(ifnot perton) 13.843
partofprojectcost)
Collectionandinternal
transfer(^Sd1.064
perton) 0.967
Equals exportparity Exportparityvalue

valueatfarmgate atfarmgate ^Sd76.938
^SdSudanesepounds.
Source:AdaptedfromWorldBank,"AppraisaloftheRahadIrrigationProject,"PA139b(Washington,D.C.,1973
restrictedcirculation),annex16,table6.TheformatofthetableisadaptedfromWilliamA.Ward,"Calculating
ImportandExportParityPrices,"trainingmaterialoftheEconomicDevelopmentInstitute,CN3(Washington,
D.C.:WorldBank,1977),p.9.
a.Scartoisabyproductofveryshort,soiledfibersnotsuitableforexportandissoldlocallyatapriceof
^Sd110.200perton.
b.Forpurposesofillustration,thereisassumedtobeaforeignexchange
premiumof10percent.Thus,thedollarvalueoftheSudanesepoundattheofficialexchangerateof^Sd1.000=
US$2.872hasbeendividedby1.1togiveanassumedshadowexchangerateof^Sd1.000=US$2.611(2.8721.1
=2.611),whereasthestandardconversionfactorisdividedby1plustheforeignexchangepremium,or0.909(1
1.1=0.909).Intheappraisalreportthatisthesourceofthistable,noforeignexchangepremiumwasassumed.
c.Seedcottonisconvertedtolint,seed,andscartoassumingthatatonofseedcottonyields400kilogramslint,
590kilogramsseed,and10kilogramsscarto.
andthisforcesuseofamorecostlydomesticalternativeandthusgreatlyreducesthecontributionoftheprojectto
nationalincome.Thesecondiswhenanimportquotaimposedonproductsthatcompetewiththeproject'soutput
makesthecontributionoftheprojectinvestmenttonationalincomehigh,eventhoughthecostofproductionper
unitofoutputfromtheprojectishigherthanthecostofcompetingimports.
Whenthedomesticcostofanimportantprojectinputishigherthantheworldmarketpricebecauseofaquotaor
prohibitivetariff,thepotentialcontributionoftheproposedinvestmenttonationalincome
Table73.EconomicImportParityValueofEarlyCropMaize,CentralAgriculturalDevelopmentProjects,Nigeria
(1985forecastpricesin1976constantterms)
Stepsinthecalculation
RelevantstepsinValue
theNigerianexampleperton
F.o.b.atpointofexport
Add localtransportandmarketingcoststorelevantmarketEquals valueatmarketConversion allowance ifnecessary
Deduct transport
andmarketingcoststorelevantmarket
F.o.b.atpointofexport
Add freighttopointofimportAdd unloadingatpoint
ofimportAdd insuranceEquals c.i.f.atpointofimportConvert foreigncurrency
todomesticcurrencyatshadowexchangerateAdd localportcharges
Using shadow exchange rate F.o.b.U.S.GulfportsNo.2U.S.yellowcorninbulk'US$116
Freightandinsurance31
(Includedinfreightestimate)
C.i.f.LagosorApapaUS$147Convertedatanassumedshadowexchangerateof4
,
q1=
US$1.47
6
X100Landingandportcharges
(includingcostofbags)22Transport(basedona
350kilometeraverage)`10
Wholesalevaluex#132
(Notnecessary)
Primarymarketing(includesassembly,costofbags,
andintermediarymargins)`12Transport(basedona
350kilometeraverage)`10Storageloss(10percentof
harvestedweight)9
Deduct localstorage,transport,andmarketingcosts
(ifnotpartofprojectcost)Equals importparityvalueatfarmgate
Add freighttopointofimportAdd unloadingatpoint
ofimportAdd insuranceEquals c.i.f.atpointofimportConvert foreigncurrency
todomesticcurrencyatofficialexchangerate
Importparityvalue
atfarmgatex#101Using conversion factors
F.o.b.U.S.Gulfports
No.2U.S.yellowcorninbulk'US$116
Freightandinsurance31
(Includedinfreightestimate)
C.i.f.LagosorApapaUS$147Convertedatofficial
exchangerateof
:~il=US$1.62
6
X91
Table73(continued)Stepsinthecalculation RelevantstepsinValuetheNigerianexampleperton
Convertnontradedgoods Convertedusingstandard
toequivalentdomestic
conversionfactorof0.909
b
valueusingconversion
factors
Addlocalportcharges Landingandportcharges
(includingcostofbags,X22)20
Addlocaltransport Transport(basedona
andmarketingcosts 350kilometeraverage,X10)`9
torelevantmarket
Equalsvalueatmarket WholesalevalueX120
Conversionallowance

ifnecessary (Notnecessary)
Deducttransport Primarymarketing(includes
andmarketingcosts assembly,costofbags,
torelevantmarket andintermediarymargins,*12)`11
Transport(basedona
350kilometeraverage,X10)`9
Deductlocalstorage,transport, Storageloss(10percentof
andmarketingcosts harvestedweight)8
(ifnotpartofprojectcost)
Equalsimportparityvalue Importparityvalue
atfarmgate atfarmgatex#92
Nigeriannaira.
Source:AdaptedfromWorldBank,"SupplementaryAnnexestoCentralAgriculturalDevelopmentProjects,"1370UNI(Washington,
D.C.,1976restrictedcirculation),supplement11,appendix2,table4.TheformatofthetableisadaptedfromWard,"Calculating
ImportandExportParityPrices,"p.10.
a.ForecastfromPriceProspectsforMajorPrimaryCommodities(1976,annex1,p.12seeWorldBank1982a).
b.Forpurposesofillustration,thereisassumedtobeaforeignexchangepremiumof10percent.Thus,thedollarvalueofthenaira
attheofficialexchangerateof*1=US$1.62hasbeendividedby1.1togiveanassumedshadowexchangerateof=P~1=US$1.47
(1.621.1=1.47),whereasthestandardconversionfactoris1dividedbyIplustheforeignexchangepremium,or0.909(11.1=
0.909).Intheappraisalreportthatisthesourceofthistable,noforeignexchangepremiumwasassumed.
c.Shadowpriceswereassumedfortransportandforprimarymarketingbecauseinthefinancialanalysisthemarketwage
overvaluedtheopportunitycostofunskilledlabor.Thevaluegivenistheopportunitycostinnaira(beforeapplyingthestandard
conversionfactor).
willbereducedbythetarifforquota.Given the policy prevailing, theprojectanalysiswillbeanaccurateindicatoroftheproject's
worth.Takefertilizer,forinstance.Ifitisexpensivetoproducedomestically,thisisanindicationthatfertilizerproductionusesa
largeamountofscarcedomesticresourcesrelativetotheresourcesnecessarytoproducesomeotherproductthatcouldbeexported
toearntheforeignexchangeneededtoimportthefertilizerfromaforeignsupplier.Butifthedomesticfertilizermust,infact,be
usedfortheprojecttomoveforward,thenitwilltakealotofdomesticresourcestoproducetheproject'sagriculturaloutput,andthe
projectwillnot,accordingly,makeasmuchofacontributiontothenationalincomeasitcouldwereimportedfertilizeravailable.If
thequotaorprohibitivetariffagainsttheinputwereremoved,thentheprojectinvestmentwouldlookquitedifferent.Achangein
tradepolicy,however,willhaveimplicationsrangingfarbeyondtheboundaryoftheprojectitself,implicationsforbothefficiencies
intheeconomyandfornoneconomicobjectives.Achangeintradepolicymaybringawiderangeofchangesinotherpricesinthe
economyaswellasinthepriceoffertilizerusedonnonprojectfarms,andtobevalidaninvestmentanalysiswouldhavetoberun
withthenewpricerelationsandincludenonprojectfarms.Predictingthesechangescouldbeverydifficultifthechangeintrade
policyweresignificant.Atbest,theprojectanalystcouldrunhisanalysisagainusingac.i.f.priceforfertilizerandmakingabroad
guessaboutwhatthechangesmightbeintherestoftheeconomybothwithinandoutsideagriculture.,Hecouldthenturntothose
responsiblefortradepolicyandsaythathisprojectanalysissignaledaneedtoconsiderwithcareremovingthequotaagainst
fertilizer.Butnotethattheprojectanalysisisonlyasignal,notacriterionfordecisionmuch,muchmoremustgointoareevaluation
oftradepolicythantheanalysisofoneproject.
Theotherimportantcaseinwhichachangeinaquotaprovesverydifficultfortheprojectanalystisthatofaquotaagainstimports
thatwouldcompetewiththeoutputofaproposedproject.Iftheimportsareprohibited,theoutputoftheprojectwillsellformorein
theprotectedmarket,andwhatotherwisemightnotbeaveryattractiveprojectmaynowmakesufficientcontributiontonational
incometobejustified.Again,ifpolicies are not going to be changed, thisisanaccurateindicatorofthecontributiontothenational
income.Butifthedomesticcostperunitofprojectoutputsay,applesvaluedatshadowpricesisgreaterthanthec.i.f.costof
importedapples,thenthisisanindicationthatitwouldbemoreefficientfromthestandpointoftheeconomyasawholeforthe
projecttoproducesomethingelse,exportittoearnforeignexchange,andthenusetheforeignexchangetoimportapples.Underthe
circumstances,theprojectanalystmaywanttorunhisanalysisagainusinganimportparitypriceandperhapsalsoadjustingsome
oftheotherpricerelationsinthedirectionhethinksmightprevailunderachangeintradepolicy.Hemayfindthatdomestic
productionwouldnotmakeenoughofacontributiontonationalincomeatthesepricestojustifytheinvestmentrequired.Hemight
alsowanttodeterminethedomesticresourcecostoftheimportsubstitutealongthelinesdiscussedinthesectionofchapter10
devotedtothattopicthiswillshowthatitcostsmoretosaveaunitofforeignexchangebyproducingapplesdomesticallythanthe
shadowexchangerateindicatestheforeignexchangetobeworth.Hisanalysishasnowsignaledthattradepoliciesshouldperhaps
bereviewed.Again,itisonlyasignaltheanalysisofthisoneprojectdoesnotitselfprovideacompletedecisioncriterion.Thetrade
policychangewillhavemanyothereffectsthatwillbefeltfarbeyondtheboundaryoftheprojectitself.
ValuingIntangibleCostsandBenefits
Themethodologyoutlinedforconvertingfinancialpricestoeconomicvaluesisonethatismostappropriatefortangiblecostsand
benefits.Whenintangiblecostsorbenefitsenterintoinvestmentconsiderations,theyraisedifficultissuesofvaluation.
Intangiblefactorshavecomeupfrequentlyinearlierdiscussionsofidentifyingcostsandbenefitsandofvaluingthem.They
compriseawholerangeofconsiderationseconomicconsiderationssuchasincomedistribution,numberofjobscreated,orregional
developmentnationalconsiderationssuchasnationalintegrationornationalsecurityandenvironmentalconsiderationsthatcanbe
bothecologicalandaesthetic,suchasthepreservationofproductiveecosystems,recreationbenefits,orfamousspotsofscenic
beauty.[Lee(1982)discussesecologicalconsiderationstobekeptinmindwhendesigningagriculturalprojectsfortropicalregions.]
Thequestionofhowtotreatintangiblefactorsmostoftenariseswhenweareconsideringthebenefitsofaproject.Many
developmentprojectsareundertakenprimarilytosecureintangiblebenefitseducationprojects,domesticwatersupplyprojects,and
healthprojectsareafewcommonones.Intangiblebenefitsareusuallynotthemajorconcerninagriculturalprojects,althoughmany
agriculturalandruraldevelopmentprojectsincludecomponentssuchaseducationorruralwatersupplyfromwhichintangible
benefitsareexpected.Whetherinagriculturalprojectsorinotherkindsofprojects,intangiblebenefits,eventhoughuniversally
agreedtobevaluable,areneverthelessvirtuallyimpossibletovaluesatisfactorilyinmonetaryterms.Yetcostsfortheseprojectsare
ingeneraltangibleenough,andtheconsiderationsoffinancialandeconomicvaluationwehavediscussedearlierapply
unambiguously.
Intangiblecostsarenotuncommon,however,andprovejustasdifficulttobringwithinavaluationsystemasbenefits.Oftencosts
aremerelytheinverseofthebenefitsthataresought:illiteracy,disease,unemployment,orthelossofaproductiveenvironmentor
treasuredscenicbeauty.
Somecostsinagriculturalprojects,whiletangible,areverydifficulttoquantifyandtovalue.Siltation,waterlogging,salinization,
andsoillossareexamples.Thesecostsshouldnotbeignored,andiftheyarelikelytobesubstantialtheyshouldbetreatedinthe
projectanalysisinamanneranalogoustointangiblecosts.
Whenconsideringprojectsinwhichintangiblebenefitsorcostsareimportant,theleasttheprojectanalystcandoistoidentifythem:
livesthatwillbesaved,jobscreated,kindofeducationprovided,regiontobedeveloped,locationofapark,ecosystemorkindof
scenerytobepreserved.
Veryoften,theanalystcanalsoquantifyintangibles:numberoflivessaved,numberofjobscreated,numberofstudentstobe
enrolled,numberofpeopleexpectedtouseapark.Evensuchsimplequantificationisoftenasubstantialhelpinmakingan
investmentdecision.
Economistshavetriedrepeatedlytofindmeanstovalueintangiblesandthusbringthemwithinthecompassoftheirvaluation
system.Thebenefitsofeducationhavebeenvaluedbycomparingtheearningsofaneducatedmanwiththoseofonewhois
uneducated.Healthandsanitationbenefitshavebeenvaluedinthenumberofhoursoflostworkavoidedbydecreasingthe
incidenceofdisease.Nutritionbenefitshavebeenvaluedintermsofincreasedproductivity.Populationprojectshavebeenvaluedby
attachingavaluetothebirthsavoided.Althoughworkintheseareascontinuesespeciallywithregardtoenvironmentalimpactfew
appliedprojectanalysesindevelopingcountriescurrentlyattempttousesuchapproachestovaluingintangiblecostsandbenefits.
Foronething,sucheffortsgenerallygreatlyunderestimatethevalueoftheintangibles.Thevalueofaneducationismuchmorethan
justtheincreaseinincomeaskanymullah,monk,orpriest.Goodhealthisablessingfarinexcessofmerelybeingabletowork
morehours.Goodnutritionisdesirableformorereasonsthanjustincreasedproductivity.Moreover,themethodologicalapproaches
usedtovalueintangiblesturnouttobeunreliableandopentoseriousquestion.Finally,theremaybemoralissuesinvolvedmany
whosupportpopulationprogramsdosooutofconsiderationsthatextendfarbeyondanybenefitcostcalculation.
Incontemporarypracticeofprojectanalysisindevelopingcountries,theonlymethodusedtoanyextenttodealwithintangible
benefitsistodetermineonapresentworthbasistheleastexpensivealternativecombinationoftangiblecoststhatwillrealize
essentiallythesameintangiblebenefit.Thisisoftenreferredtoas"leastcostcombination"or"costeffectiveness"(foranapplication
ofthemethodtosanitationprojects,seeKalbermatten,Julius,andGunnerson1982,chapter3).Ifthesameeducationbenefitscanbe
providedbycentralizedschoolsthatrealizeeconomiesofscalebutrequirebusesorbymoreexpensivesmallerschoolstowhich
studentscanwalk,whichschoolsarecheaper?Canthesamehealthbenefitsbeprovidedatlesscostbyconstructingfewerlarge
hospitalsbutmoreclinicsmannedbyparamedicalpersonnel?Byconstructingawaterborneseweragesystemorbyinstallinglow
costhouseholdsanitationfacilitiesthatdonotrequiresewers?Canthesamenumberoflivesbesavedmorecheaplybybuyingupall
thepropertyrightsinafloodplainandmovingpeopleoutthanbyconstructingdykesandlevees?Giventwoparksitesthatwould
givesimilarrecreationbenefitsperhapsonethatwouldrequirebuyingwarehousesitesandanotherthatwouldrequireextensive
fillingandfloodcontrolalongariverwhichwouldbecheaper?Onceitisdeterminedthattheleastexpensivealternativehasbeen
identifiedanditscostsvalued,thenthesubjectivequestioncanbemorereadilyaddressed:isitworthit?
Interestinglyenough,electricityprojectsarecustomarilyanalyzed
usingleastcostcombination.Themarginalvalueproductofelectricityisingeneralconsideredgreatlyunderstatedbythe
administeredpricechargedinanyevent,muchelectricityisusedforhomelightingthatisverydifficulttovalue.Inpractice,most
powerprojectssimplycomparealternativemeansofproducingthesameamountofpower:steamgeneratingstationsversusa
hydroelectricdamalargegeneratorwithtransmissioncostsandseveralyearsofidlecapacityversusaseriesofsmallerstations
closetothedemandcenters.
Avariationoftheleastcostcombinationmethodcanbeusedtodealwithintangiblesinmultipurposeprojects.Fromthetotalcostof
theprojectaredeductedallthosecoststhatcanbedirectlyattributedtotangiblebenefitsflooddamageavoided,irrigation,
navigation,andthelike.Thesecostsarecomparedwiththeirassociatedbenefitstodetermineifthepurposeisworthwhileatall.Is
theflooddamageavoidedworththedirectcostsincurred?Finally,theresidualcostsfortheprojectarecomparedwiththeresidual,
intangiblebenefits.Isthenumberoflivessavedbytheprojectworththeresidualcostthatmustbeincurred?(Amethodofallocating
residualswasoutlinedinthesectiononjointcostallocationinchapter6.)
Theproblemswithvaluingintangiblesaremorecommonandmoredifficulttodealwithinsectorsotherthanagriculture.In
agriculturalprojects,mostofthebenefitsusuallyaretangibleandcanbevalued.Thecostsandbenefitscanbecompareddirectlyto
choosethehighestyieldingalternative.Thereare,however,severalaspectsofintangiblebenefitsthatarefrequentlyencounteredin
agriculturalprojects.Agriculturalextensionservices,forexample,aresometimesconsideredtogiveanintangiblebenefitingreater
farmereducation.Forthemostpart,itisbesttotreatsuchcoststhatmaygiverisepartlytointangiblebenefitsor,atleast,the
incrementalamountofsuchcostsasnecessarywithinaprojectifthetotal,tangiblebenefitsaretoberealized.Ifadairyproduction
projectrequireshelpingfarmerstolearnbettersanitationprocedures,thentheextensionagentswhoteachtheproceduresare
essentialtothesuccessoftheproject,andthebenefitoftheireffortisthetangibleoneofmoreandbettermilk.
Inruraldevelopmentprojects,thereareoftencomponentsthatarehardlyessentialtothemainproductionobjectivesandthatproduce
generallyintangiblebenefits.Thisisthecasewhenvillageschools,ruralwatersupplies,ruralclinics,orevenagriculturalresearch
costsareincludedinaproject.Ifthesecomponentsarerelativelysmallincomparisonwithtotalprojectcosts,astheyoftenare,then
theproblemofvaluingthebenefitsmaybeignored.Butifsuchcomponentsformasignificantpartoftotalprojectcost,they
probablyshouldbeseparatedoutandtreatedonaleastcostcombinationbasis.Thisprocedurewasfollowedintheanalysisforthe
KoreaRuralInfrastructureProject.Theprojectincludedirrigation,feederroads,communityfuelwoodplots,ruraldomesticwater
supply,andruralelectrification.Theirrigation,feederroads,andcommunityfuelwoodcomponentswereanalyzedby
comparingtheirtangiblecostswiththeirtangiblebenefits,butthecomponentsforruraldomesticwater
supplyandruralelectrificationwereeachdealtwithseparatelyonaleastcostcombinationbasis.
Finally,iftheproposedprojectisoneinwhichtheoutputiswhollyintangible,aleastcostcombination
approachisappropriate.Thiswouldprobablybethecaseforagriculturalprojectsinwhichthemajor
investmentisinextension,agriculturaleducation,ruralwatersupply,ruralhealthimprovement,or
research.
DecisionTreeforDeterminingEconomicValues
A"decisiontree"fordeterminingeconomicvaluesisgiveninfigure71,partsAD.Mostissuesof
economicvaluationinagriculturalprojectsarecoveredbythisdiagram.Thedecisiontreeisusedby
takinganitemtobevaluedinanagriculturalprojectandtracingthroughthetree,followingeach
alternativeasitappliestotheitemuntiltheendofthetreeisreached,whereasuggestionabouthowto
valuetheitemwillbefound.
Toillustrate,wemaytracethroughafewcommonelementsinagriculturalprojects.Takefertilizertobe
usedinanirrigationprojectthatwillproducecotton.Thefertilizeristangible,involvesrealresource
use,istraded,isaprojectinput,andwouldbeimportedwithouttheproject.Therefore,itisvaluedatthe
importparityprice.Ortakeagriculturallabortobeusedtoapplythefertilizer.Itistangible,involves
realresourceuse,isnontraded,isaprojectinput,isnonproduced,islabor,andwouldbeunderemployed
withouttheproject.Therefore,itisvaluedbytakingthemarginalvalueproductofthelaborinits
withoutprojectemployment.(Notethatlaborisdefinedasatangibleitem,apossiblesourceof
confusioninusingthedecisiontree.)Ortakeataxonthefertilizer.Itistangible,isadirecttransfer
payment,isapaymenttoorfromgovernment,andisatax.Therefore,itisomittedfromtheproject
economicaccount.Or,finally,takethecottontobeproducedintheproject.Itistangible,involvesreal
resourceuse,istraded,isaprojectoutput,andwillbeanexport.Therefore,itisvaluedattheexport
parityprice.

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