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	Table of Contents
p. 53 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 11 : Valuation of Nontraded Outputs and Inputs

I. Nontraded Outputs

1. As with traded goods and services, the economic price of nontraded outputs is derived from a weighted average of the supply and demand price for nonincremental and incremental production. Economic and financial prices differ because of taxes and subsidies on outputs, taxes and subsidies on the inputs being used to produce the nontraded outputs, and the monopoly supply situation of some suppliers. They may also differ because the government regulates prices and does not set prices in relation to costs, and because factors of production are not priced according to their economic value.

2. The demand and supply of nontraded outputs is affected by their financial price. Because the market for nontraded goods is the market within the domestic economy only, a project may have a significant impact on the supply of output and on the average costs of production. A major project to produce nontraded goods therefore is likely to affect both the supply price and the demand price. In many cases, the with project prices will differ from the without project prices. The extent of nonincremental and incremental production depends on the elasticity of demand and the elasticity of supply in relation to changes in financial prices.

3. Figure 1 illustrates this situation for a nontraded good produced in a competitive market. As the supply price falls, nonincremental project output will partly substitute for existing production. Existing consumers will benefit as the price fallsa consumer surplus. However, at the same time existing producers will lose incomea loss of producer surplus. The nonincremental output should be valued through the average supply price without and with the project. At the same time, project output will expand overall supply and bring about a fall in the demand price. New users will benefit from the expanded output. The incremental output should be valued through its average demand price without and with the project. Project output as a whole, therefore, should be valued through the weighted average of the supply and demand prices, with the weights depending upon the level of nonincremental and incremental output.

4. Many nontraded outputs, especially in the public sector, are not produced in a competitive framework. For example, piped water supplies may be produced by a single agency and substitute entirely for nonpiped supplies in the project area. In this case most of the output will be nonincremental, valued through the average of the without and with supply prices. Moreover, the price of piped water supplies may be regulated by government and sold at a fixed price irrespective of the level of costs. In this case, the value of the incremental nontraded output, which may be a small part of total project output, can be valued through its demand price. The basic approach can also be applied to the situation where, along with a project investment, user charges are raised for the nontraded output. The increase in user charges has to be converted into a projected demand for the output, and the investment scaled accordingly, bearing in mind that demand for nontraded services is affected by factors other than price, for example the growth of the population or the growth in overall production. In this case, there also will be a high level of nonincremental output affected by the increase in price; however, the nonincremental output should still be valued through its average supply price. The incremental output can be valued through its average demand price, taking account of the increase in price.

5. When the quantity and price have been projected without and with the project, the resulting levels of nonincremental and incremental outputs need to be revalued at shadow prices in order to calculate the economic internal rate of return for the project. This involves taking the weighted average of the demand and supply prices and adjusting them for the value of foreign exchange and labor. If the assumptions on price levels and demand and supply responsiveness change, then the projected financial demands, revenues, and costs will change; so too will the average supply and average demand prices, as well as the proportions of nonincremental and incremental project output. In other words, a change in the financial assumptions will also bring about a change in the economic results. Where supply and demand relates to the world markets for traded goods, changes in financial assumptions are unlikely to change economic prices. Where supply and demand relates to the domestic market for nontraded goods, any change in financial assumptions is likely to alter the balance between economic costs and benefits as well.

The EP of a Competitive Nontraded Output: Bus Services

6. A public sector company is considering expanding services on a city bus route using newer buses with a larger capacity and lower operating costs. At present there are 60,000 return trips per month on the route. The present price is P11, made up of P10 for the operating company and a 10 percent sales tax. It is not expected that the price or number of trips would change without the new bus project. The new buses would provide 30,000 trips per month at a total price of P9.9, made up of P9 for the bus operator and the 10 percent tax. On the basis of a consumer survey, it has been estimated that the total number of trips would rise to 80,000 at this price level. In other words, a new bus service would substitute for existing bus services for 10,000 trips per month (nonincremental output), and increase the overall number of trips by a further 20,000 (incremental output).

7. The new bus service, like existing services, would rely on imported vehicles. The cost breakdown for bus services will be similar both without and with the project. This cost breakdown is given in Table 1. The supply price for the driver is approximately 75 percent of the wage that would be paid. The economic price of foreign exchange has been estimated at 20 percent higher than the official rate. Table 1 also shows the cost breakdown of supplying bus services revalued in economic prices using the domestic price numeraire. The extra cost of bus services in shadow prices is 7 percent higher than their financial price to the bus operator.

Economic costs using domestic price numeraire.

8. The gross economic benefits of the bus supply project is given by the nonincremental output times the average adjusted supply price plus the incremental output times the average adjusted demand price. The average adjusted supply price is derived from the without project cost of P10 per trip and the with project cost of P9 per trip. The average supply price of P9.5 is converted to an economic price using the conversion factor from Table 1 of 1.070. This gives an economic supply price of P10.165. The average demand price is the average bus fare per trip without and with the project. The fare is P11 without and P9.9 with, giving an average demand price of P10.450.

9. The gross economic benefits for the bus service project can be calculated from the nonincremental and incremental outputs and the economic supply and demand prices (see Table 2). These gross economic benefits can be compared with the revenue to the new bus operator, which will be 30,000 trips at P9 per trip, or P270,000. The resulting conversion factor is 1.151, which can be applied to the revenue accruing to the new bus operator to derive the economic value of the bus services provided.

The economic value of the bus services provided by the new project is P310,650, in the domestic price numeraire.

10. The bus services project takes place in a competitive environment. Many public services such as water supply projects take place in an environment that is not fully competitive. In this example a piped water supply project to extend an existing scheme is expected to displace present sources from household wells and private vendors. While the private vendors and households supply and purchase water in a competitive environment, the government subsidizes public supply schemes. The subsidy and the higher quality of the piped supplies ensures that the other water sources will be fully displaced.

11. Without the project, water demand in the area would be 120,000 cubic meters (m3) per year. The financial price for these supplies is P40 per m³ or the 20 percent of water supplies derived from private vendors and P10 per m³ for the 80 percent of water supplies derived from operating household wells. These financial prices include the costs of home processing of water to a quality close to that of the piped supplies. The price of piped water supplies from the public system is only P5 per m³, which is lower than its cost of supply. At this level of charge for the new supplies, it is expected that demand will increase to 180,000 m³ per year.

12. The nonincremental water should be valued through its without project supply price (SP). This is the cost of water supplies to the customer, that is, after water losses, that will be saved through the new provision. The financial and economic cost of water without the project is given in Table 3. Fifty percent of the cost of supply from private vendors reflects labor costs, with a supply price 85 percent of its wage. Eighty percent of the supply price of household wells reflects traded components for the pumps, fuel, and treatment process. The economic price of foreign exchange is 30 percent above the official exchange rate, implying a standard conversion factor (SCF) of 1/1.3 or 0.769.

Economic values using world price numeraire.

13. The incremental water to the customer should be valued through its average demand price. The average cost of water without the project in financial prices is P16 per m³. With the project this cost will fall to P5 per m³. The average demand price of P10.5 per m³ needs to be converted into its world price equivalent using the SCF. The average economic demand price is P8.075 per m³.

14. Table 4 calculates the weighted average economic price of water to the customer. The weighted average economic price is applied to the water supply output to give the gross economic value of the water supply output (see Table 4 and Figure 2).

15. The economic value of the water can be compared with the financial revenue from the water supply project, which is 180,000 m³ at P5 per m³, or P900,000, to give a conversion factor for water sales of 2,083,320/900,000 = 2.315. This conversion factor is calculated using the world price numeraire. It can be used to convert the supply of water at the level of the customer from its financial to its economic value.

II. Nontraded Inputs

The EP of an Expanding Nontraded Sector: Power

16. A private sector mineral processing project requires a large amount of power per unit of output. The power sector is being expanded and provision is being made to meet the future demands of the mineral processing project. The power input should be valued at the average of its demand and supply price. In the case of an input, incremental production is valued through its average supply price, while nonincremental production is valued through its average demand price. In this case, the extra demand for power as an input will be met through incremental power output, and so it should be valued through its average supply price (see Figure 3).

17. The power sector is experiencing increasing costs. It is expected that the supply cost of power will increase with the project. The average supply cost in financial prices without and with the project has been calculated; however, this value needs to be converted to economic values, and related to the charge being made for power. Power charges are heavily subsidized, and the cost breakdown for power includes a substantial transfer element. The cost breakdown by proportion without and with the project is assumed to be similar, and is given in Table 5.

Economic values using world price numeraire.

18. The present charge for power is P0.90 per kwh. This charge includes a financial subsidy of P0.80 per kwh. The economic supply price of power is calculated as P1.65 per kwh. Where the extra demand for power from the mineral processing project will be met through the expansion of the power sector, that is, entirely from incremental production, the conversion factor of 1.833 should be applied to convert the cost of power to the project into its economic value to the economy as a whole.

The EP of Water Inputs

19. A new industrial project has a high demand for water per unit of output. The water will be drawn from the public supply and treated further in the industrial plant itself. The treatment costs have been included in the project costs. Three-quarters of the extra demand for water by the industrial project will be met from an expansion of supply. This incremental water supply should be valued through its average supply price.

20. The new public water supplies will in part use water that at present is being used for agricultural purposes as there is a strict limit on the amount of water that can be drawn from the common water source. One quarter of the extra demand for water will be drawn away from agricultural uses. This nonincremental water input should be valued through its average demand price. For simplicity, it is assumed that the demand price for agricultural uses is not affected by the project, that is, the without and with demand prices are equal.

21. The cost of extra water supplies to consumers can be converted from financial to economic value (see Table 6). It is assumed that the cost structure for existing water is not different from the new project. Because water is heavily subsidized, its economic value is much greater than its financial value. Also, part of the cost of water includes the cost of power, which itself is subsidized (see the previous example). The SCF for the country is 0.9, and the supply price of labor is 85 percent of its wage.

Economic values using world price numeraire.

22. The value of water in agricultural uses is estimated through the marginal loss of net agricultural output, at shadow prices, per unit of water diverted to the new users. Agricultural prices for the staple crops grown in the area are regulated, and some of the inputs are subsidized. The net effect is expressed in a conversion factor relative to the financial cost of a unit of water. Again, because agricultural water use is also subsidized, this conversion factor, at 1.673, is considerably above one, even using the world price numeraire.

23. The CF for the water inputs is the weighted average of the CFs for incremental and nonincremental supplies. Seventy-five percent of project supplies is incremental and 25 percent is nonincremental. The weighted average CF is

CF = 0.75 * 2.588 + 0.25 * 1.673 = 2.359

The financial charge for water supplies should be multiplied by this CF to give the economic value at the world price level of the project supplies (see Figure 4).

III. Nontraded Outputs Without Charges

Estimating Demand for Public Service Projects

24. In many public projects, no price is charged for the output. Where the marginal costs of an extra person using a public good is close to zero, the efficiency price is also close to zero. In these circumstances, it is expected that 100 percent of those having access would use the public good concerned. To value the output of the public good, it is necessary to construct a surrogate demand curve showing the demand for the service at different levels of hypothetical charges.

25. As an example, a primary health care project supplying free health care to a poor community is to be established. At present, supply is only available on a private basis in a nearby town. However, this facility is already fully utilized, even though it involves the cost of consultation and treatment as well as the cost of getting there and back. Because the primary health services will therefore be fully incremental to existing supplies, they should be valued at their average demand price.

26. Figure 5 illustrates this situation, and provides a surrogate demand curve through which the health services can be valued. One extreme point of the demand curve is for the new provision, where all the population demand basic health services at a price of zero. The other extreme of the demand curve is given by the present full cost of access and treatment at the private clinic in the town. At this price, there is no incremental health service provision. The gross economic benefits of the health service project are given by the incremental quantity provided (Q_W - Q_WO) valued through the average demand price (P_WO - P_W )/2. Where the without quantity is zero, and where the with project charge is zero, this reduces to (Q_W * P_WO )/2, and the economic value per unit of output can be valued through P_WO/2. This value can then be converted to economic prices by making adjustments for the value of foreign exchange and labor.

27. An additional example is a rural water supply project that would provide reliable supplies to a village. At present the water supply is free and all households in the village use it. However, contingent valuation has been applied in the village through a survey to test how many households would be willing to pay different levels of fees to be introduced with the supply improvement. The basic result is that only 60 percent of households would be willing to continue using the supply at a fee level of Rs250 per month for access to the water.

28. These two points can be used to derive a surrogate demand curve for the water supply (see Figure 6). One hundred percent of households would use the supply at a zero charge; 60 percent at a charge of 250. The slope of the demand curve is -250/(100 - 60) or -6.25. By extrapolation, all households would give up using the supply at a charge of Rs625 per month. The water supply project can then be valued through its average demand price, 625/2 (using the domestic price numeraire).

29. There are two basic problems with such a procedure for deriving surrogate demand curves through contingent valuation methods. The first is the difficulty of obtaining reliable answers to how households would react in hypothetical situations. Often households undervalue public services in the expectation that they will be free anyway. The second is the simple assumption about the shape of the demand curve, a straight line, through which the maximum charge of Rs625 is derived. Other shapes can be used over a smaller range when it is felt that the approach here is not realistic.

30. Rather than rely on contingent valuation, where hypothetical situations are posed to respondents, as far as possible surrogate values can be derived through related market behavior. Where a nonmarketed good is an intermediate product, for example irrigation water, it can be valued through the market value of the extra crop production to which it contributes. In the same spirit education expenditures for which there is no charge can be valued through the incremental income that accrues to those with better qualifications.

31. Where the nontraded good or service has a close substitute or a complementary good, either may be used to derive a price through which it can be valued. An example of substitution is that of the public and private health services above. An example of a complementary good would be the demand for television sets through which a television transmission project could be valued. The market value of the transmission project can be taken to be at least equal to the amount people or enterprises are willing to spend to access the transmission. Where different neighborhoods experience different levels of pollution, a project oriented to reducing pollution could be valued through the difference in property prices or rents between neighborhoods.

32. Where nontraded outputs without charge have no close substitutes or complements, and where resources or circumstances are not conducive to contingent valuation methods, valuations for similar projects in a different location or even a different country could be applied to a new project. Such benefit transfer approaches must be closely scrutinized and argued, with appropriate adjustments for differences in context.

33. The following steps summarize the procedure for estimating the economic value of nontraded outputs and inputs.

1. Identify the effects of project outputs and inputs. Will the effects be limited to the domestic market for the outputs and inputs?
2. For project outputs:
• What is the market structure?
• What will be the effect of the project on quantity and price, of the project output and of any substituted products?
• How much of the project output will substitute for the output of other producers (nonincremental) and how much will add to supply (incremental)?
• What are the marginal costs of substituted outputs, as a combination of traded and nontraded costs?
• What is the willingness to pay per unit for the incremental supplies?
3. For major project inputs:
• What is the market structure?
• What will be the effect of project demands on the quantity and price of the input?
• How much of the additional project demand will be met by extra supply (incremental) and how much by reduced supplies to others (nonincremental)?
• What are the marginal costs of producing the incremental supplies, as a combination of traded and nontraded goods?
• What is the willingness to pay per unit for the nonincremental supplies?
4. Adjust the willingness to pay and the cost estimates to the chosen numeraire.
5. Calculate the weighted average economic value of the project output, using the proportions of incremental and nonincremental demands as the weights.
6. Calculate the weighted average economic value of the project input, using the proportions of incremental and nonincremental demands as the weights.
7. Compare the resulting economic prices with the financial prices.

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