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p. 52 of 74 BACK | NEXT I. Introduction II. Background III. The Economic Rationale of A Project IV. Macroeconomic and Sectoral Context V. An Integrated Approach To Economic Analysis VI. Identification and Quantification of Costs and Benefits VII. Valuation of Economic Costs and Benefits VIII. Large Projects, Linkages, and National Affordability IX. Least-Cost and Cost-Effective Analysis X. Investment Criteria: Economic Viability XI. Discount Rate XII. Uncertainty: Sensitivity and Risk Analysis XIII. Sustainability of Project Effects XIV. Distribution of Project Effects XV. Projects and Policies XVI. Appendices Appendix 1: Key Questions For The Economic Analysis of Projects Appendix 2: Project Economic Rationale: Market and Nonmarket Failures Appendix 3: The Project Framework Appendix 4: Identification and Measurement of Consumer Surplus Appendix 5: Treatment of Working Capital Appendix 6: Depletion Premium Appendix 7: The Use of Constant Prices In The Economic Analysis of Projects Appendix 8: General Methodology For Building Up Project Statements Appendix 9: Economic Evaluation of Project Output and Input Appendix 10: Economic Price of Traded Goods and Services Appendix 11: Valuation of Nontraded Outputs and Inputs Appendix 12: Shadow Wage Rate and The Shadow Water Rate Factor Appendix 13: The Economic Price of Land Appendix 14: Treatment of Resettlement Components of Projects Appendix 15: Calculating Economic Prices At The Domestic Market Price Or World Market Price Levels Appendix 16: Estimating The Shadow Exchange Rate Factor and The Standard (Or Average) Conversion Factor Appendix 17: Example of An Economic Rate of Return: An Irrigation Rehabilitation Project Appendix 18: Effect On Net Foreign Exchange and Budget Flows: An Example Appendix 19: Least-Cost Analysis and Choosing Between Alternatives Appendix 20: Estimating The Economic Opportunity Cost of Capital Appendix 21: The Treatment of Uncertainty In The Economic Analysis of Projects: Sensitivity and Risk Analysis Appendix 22: User Charges, Cost Recovery, and Demand Management: An Example For Piped Water Appendix 23: Financial Returns To Project Participants: An Illustration Appendix 24: Economic Evaluation of Environmental Impacts Appendix 25: Distribution of Project Effects Appendix 26: Impact On Poverty Reduction Appendix 27: Difference Between Economic and Financial Prices Appendix 28: Use of Economic Prices In Measuring Effective Protection Appendix 29: Exchange Rate Issues In Project Analysis XVII. Others

Guidelines for the Economic Analysis of Projects : XVI. Appendices

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Appendix 10 : Economic Price of Traded Goods and Services

1. The economic price (EP) of traded goods and services is determined within the conceptual framework outlined in Appendix 9. Traded goods and services are those whose production or use by a project has an effect on the countrys balance of payments, because either the goods and services themselves are exported or imported, or because they are substitutes for goods that are exported or imported.

2. Typically, Bank-assisted projects are small relative to the size of world markets. Projects face an infinitely elastic demand for traded output and an infinitely elastic supply for traded input. Consequently, world market prices are not affected by project supply of output or project demand for input. This represents a special case where increases in the supply of output or in the demand for inputs have no effect on their prices.

3. The valuation of traded goods can be illustrated for the four main cases: exported output, importable output, imported inputs, and exportable inputs. If world demand is elastic, exported output is incremental to world supply and the EP is based on the demand price (DP), which is the free on board (FOB) price. This compares with the financial price (FP) of an export at the border, which can be given by the FOB price less net export taxes (t = export tax less export subsidy) (see Figure 1). If world supply is elastic, importable output is nonincremental to world demand and the EP is based on the supply price (SP), which is the cost insurance freight (CIF) price. This compares with the FP at the border, which is the CIF price plus net import tariff (t = import tariff less import subsidy) (see Figure 2).

S(P) = with project supply.

4. If the world supply is inelastic, then imported input is incremental to world demand and the EP is based on the SP, which is the CIF price. The FP at the border of an imported input is the CIF price plus import tariff less the import subsidy (see Figure 3).

5. If world demand is inelastic, an exportable input is nonincremental to world demand and the EP is based on the DP, which is the FOB price. The FP at the border of an exportable input is the FOB price less export tax plus export subsidy (see Figure 4).

6. The economic price of traded goods need to be adjusted for the location and price level in which the analysis is being conducted. In most cases, the price level is the price level of the project and the location is the project location. The world market price (WMP) needs to be adjusted to the project situation by subtracting or adding handling, distribution, transport, and processing costs between the project location and the port of entrythe result is the border price equivalent value (BPEV). All these nontraded costs need to be expressed in economic prices (see Appendix 11).

7. When this adjustment has been made, the BPEV can be compared with the FP of the same project output or input at the project location FP(P). This comparison can be expressed in the form of a conversion factor (CF). The CF is given by

BPEV Border Price Equivalent Value
FP(P) Financial Price at Project

Where economic prices are considerably below financial prices, the CF will be significantly less than 1. This will apply for highly protected outputs and inputs. Where economic prices are considerably above financial prices, the CF will be significantly more than 1. This will apply for export products that are heavily taxed.

I. The EP of an Exportable Output

8. If the output of a project increases the countrys supply of an exportable good, and the additional output does not affect the world price of that good, then the economic price of the projects output delivered to the port is measured by the FOB price of the good. The FOB price will in turn be equal to the price received by the producer, plus the financial costs of handling, distribution, transportation, and processing (HDTP) from the project site to the point of export, plus any net export tax on the good. The economic price of an exportable good at the project site is, therefore, the FOB price minus the economic values of HDTP minus net export taxes.

9. Suppose a country exports timber logs that are used by the wood processing industry abroad. The current level of exports is 40,000 cubic meters per month and the world price is $600 per cubic meter. It has been estimated that if the country decides to increase its logging activity so that the present exports go up by 25 percent, all the output would be incremental to world output, and the FOB price would not be affected. In this case, the various components of the economic benefit or price per cubic meter of logs is described below, with local currency represented in RM:

10. The EP and FP of the timber at the project location can be computed based on the EP of handling and transport items (see Tables 1 and 2).

^a Economic price using world price numeraire.

While the financial price for timber at the project site is RM12,900, the economic price of timber at the project site is RM15,966. The timber is worth more to the national economy than to the timber producers. The conversion factor of 15966/12900 = 1.238 can be used to convert the financial to the economic price of timber at the project (using the world price numeraire).

II. The EP of an Import-Substitute Output

11. If a project produces an import substitute good, its economic price is the foreign exchange saved by the country through reduced imports, adjusted for differences in the economic costs of HDTP. Thus, the benefit of producing such a good is the CIF price of imports, plus the economic costs of HDTP from the port to the domestic market, minus the economic costs of HDTP from the project to the domestic market.

12. This can be illustrated through the following example where a project will assemble irrigation pumps, which were previously imported, for domestic consumption. It has been estimated that the extra production of pumps will be nonincremental to world output, that is, they will simply substitute for existing imports at prevailing prices. The various components of the economic benefit of the pumps are as follows:

13. This time, all economic prices will be estimated at the domestic price level. The EP of handling, transport, and the pumps is given in Table 4, using the same values for the official exchange rate of 30 RM/$ and the shadow exchange rate of 36 RM/$. The EP and FP of the pumps at the project site can be compared as follows (Table 3).

^aEconomic price using domestic price numeraire.

While the financial price of pumps at the project site is RM1,665, the economic price at the project site is RM1,347.3. The CF for pumps of 1,347.3/1,665 = 0.804 can be used to convert the financial to the economic price of pumps (using the domestic price numeraire). The pumps are worth less to the national economy than to the project sponsors.

III. The EP of an Imported Input

14. A projects requirement of an imported input will cause an increase in the total imports of the country even if the project does not directly import the item. If the price of the good in the world market does not change with this additional demand, the economic cost of the input at the countrys border is the CIF price. The full economic cost of this item at the factory site will include the economic costs of handling and transportation from the port to the project site. This can be computed in a similar manner to the economic price of an import substitute output.

IV. The EP of an Exported Input

15. A project may use an input that otherwise could have been exported. The relevant cost is the benefit foregone by consuming the good at home instead of exporting it. In this case, the FOB price should be adjusted for the difference in the economic costs of handling and transportation to the port, which is now saved, and to the project site from the source of supply.

V. Import Substitute and Exportable Output

16. Project outputs and inputs can be incremental and nonincremental. A particular output or input may be both. The project to establish domestic production of irrigation pumps may also produce for export. The EP of exportable pumps is calculated in Table 5 from the FOB price of pumps. The economic value of an exported pump (1124.7) is less than the economic value of an import substitute pump (1347.3).

^a Economic price using domestic price numeraire.

17. Nonincremental (import substitute) output is valued at its supply price based on the CIF cost of a pump. Incremental (exportable) output is valued at its demand price based on the FOB price of a pump. The EP of a pump is the weighted average of its supply and demand price. The weights attached to the supply and demand price in the early project years are 0.8 and 0.2, respectively. Over time, however, it is expected that the project will increase the proportion of output exported. Table 6 shows the weights for the supply and demand price for three phases of the project and the corresponding economic prices. As the proportion of exports rises, the weighted average EP falls somewhat. Different CFs should therefore be used in different phases of the project to convert the financial price into the corresponding weighted average EP (see Table 6).

Economic price using domestic price numeraire.

VI. Large Projects: Elasticities and Price Changes

18. The EP of a good is the weighted average of its demand and supply price. Most projects will have no effect upon the price level of either outputs or inputs. The supply of output will be fully incremental when the demand for project output is price elastic. In this case, the demand weight is 1.0 and the EP is the demand price. Similarly, where the demand for project output is inelastic, the supply of output will be nonincremental, the demand weight is zero, and the EP is the supply price (see Table 7).

19. Similar arguments apply to additional project inputs. Where supply of an input is price elastic, the supply weight is one and the EP is the supply price. Where supply of an input is price inelastic, the supply weight is zero and the EP is the demand price.

20. However, if a project is large or if demand for output or supply of inputs is not perfectly elastic, then the EP of project items needs to be calculated in a way that allows for changes in price between the without and the with project cases. For a large project, the extra supply of output may cause a reduction in price. The with project price can be calculated using elasticity estimates for the elasticity of supply of other producers when the price falls, and the elasticity of demand for other purchasers as the price falls. If the elasticity of supply is large relative to the elasticity of demand, then the weight on the with project supply price will be large (approaching 1.0 for the import substitute case). If the elasticity of demand is large relative to the elasticity of supply, the weight on the demand price will be large (approaching 1.0 where supply is fixed).

21. A large project may create additional demand for an input that affects the market for that input in two ways: producers may increase supplies as a response to the increase in price; some consumers may reduce their purchases as a result of the increase in price. The new price of the input will depend on the relative elasticities of supply and demand. If the elasticity of supply is large relative to the elasticity of demand, the EP of the input tends toward its supply price. If the elasticity of demand is high relative to that of supply, the EP tends toward its demand price.

22. Because large projects may have an impact on the prices of outputs and inputs, the effects on existing suppliers or users also have to be considered. A new project that brings about a reduction in the DP for the output on the world market will cause a loss of earnings to existing producers. This loss should be subtracted from the economic value of the output. A new project that increases the price of a traded input will cause a loss to existing users of the inputs. This loss also must be subtracted from the net economic benefits of the projects.

23. The following steps summarize the procedure that is followed in valuing tradable outputs and inputs.

1. Identify the effects of additional project output. Will the effects be felt in terms of trade?
2. Identify the effects of additional demands for project inputs. Will the effects be felt in terms of trade?
3. Estimate the trade effects of outputs: extra exports, less imports, a combination of the two.
4. Estimate the trade effects of inputs: less exports, more imports, a combination of the two.
5. Take account, exceptionally, of price effects in the world market for outputs and inputs.
6. Identify the fob and cif prices for extra exports and extra imports. Identify the equivalent traded good, for substituted imports or exports, and their cif and fob prices. Adjust for quality differences where necessary.
7. Estimate the associated costs to/from the market or project site.
8. Adjust all values to the chosen numeraire.
9. Summarize the border price equivalent value.
10. Compare the economic price with the financial price for the same good.

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